When Counterparties Fail (Waters Special Report)

The demise of Bear Stearns and Lehman Brothers has thrown the default threat onto center stage. Credit risk is guiding trading strategies like never before as technologists scramble to provide the front office with real counterparty risk measurement. By Joe Morgan

When Bear Stearns collapsed in the spring of last year it completely changed the thinking of risk managers across the globe. Gone were the days when capital markets firms could simply focus their attention upon the risks of financial products blowing up. Buy- and sell-side firms now had to ask the question: Will the firm we are doing business with still be around tomorrow?

Anyone misguided enough to believe that it could still be "business as usual" in the capital markets after the demise of Bear Stearns had their illusions shattered when Lehman Brothers filed for Chapter 11 bankruptcy protection last September.

"Counterparty credit risk came to the forefront after Bear Stearns. The fact that even a major global bank could disappear scared everyone," says Kevin McPartland, a senior analyst at consultancy firm Tabb Group in New York. The collapse of giants in the financial world has completely changed capital markets firms' attitude toward counterparty credit risk. It would have previously been unthinkable that a credit default swap (CDS) purchased from a bulge-bracket firm would become worthless in the wake of the bank failing. Now risk managers have to consider the dual threats of both the underlying financial risk that a CDS is taken out to protect against, and the risk of the bank arranging the trade collapsing. This has increased the overlap between risk management and trading like never before.

Market analysts point out that capital markets firms are increasingly providing traders with the facility to check with the firm's credit risk models before executing trades. Those without automated processes in place to link a credit department's risk data with its trading desks are requiring traders to pick up the phone more often and speak with risk managers, particularly before executing major transactions.

Chicago-based complex event processing (CEP) technology vendor Aleri claims it has experienced a recent upsurge in demand-particularly among sell-side firms-for its suite of solutions. CEP technology consolidates trades, market prices, and settlement reports, enabling a firm to obtain an updated view of risk exposure in real time. In addition, a firm can impose pre-trade limits and caps on the exposure dealers can take with a particular counterparty.

"The bottom line is that many firms that have collected information in the past have not done so in a timely enough fashion," says Jeff Wootton, vice president at Aleri in Chicago. He says the CEP system takes native data from different risk and trading systems within a firm and aggregates it along different dimensions in real time. "From the consolidated view, you can then drill down all the way to the individual transaction level, managing trading positions and exposure in a certain asset class, location or with a particular counterparty."

Buy-side and sell-side firms have also been forced to replace risk models in the wake of the financial crisis. PJ Di Giammarino, CEO of JWG-IT Group, a financial services think tank based in London, describes the counterparty risk management framework used by capital markets firms a year ago as "fundamentally flawed." He says there is now a need for more timely and granular customer information on demand. "However, this higher quality data needs to be distributed across the firm without slowing down its trading desk. Reducing latency of changes in the customers' state is critical. Time is a luxury firms do not have," he says.

Bob Giffords, an independent banking and technology analyst based in the UK, says risk models now have to be redesigned and recalibrated for new correlation risks and to fit them into "the rapidly diminishing interstices between trades." He expects this to require more hardware along with a closer scrutiny of the links between financial products, especially via liquidity, contagious market sentiment, or external political events. "Multi-model strategies may well start to emerge as we've seen for investment," says Giffords. Different models show different risk factors and are then weighted based on market or even political conditions. "When the market is jittery and trading is thin, sentiment models may dominate, while during more confident, liquid periods we would expect to see models based on fundamentals to increase their weighting," he says.

Rohan Douglas, CEO of Quantifi, a financial software vendor in London, says the current financial crisis has resulted in regional banks and many large buy-side participants adopting a sophisticated approach to counterparty credit risk that was previously the almost exclusive purview of bulge-bracket firms such as Goldman Sachs. Risk modeling techniques used to price financial instruments are being used to measure the counterparty risk on individual trades. However, Douglas says that firms scrambling to implement more stringent counterparty credit checks now in the wake of the current market turmoil are still in danger. "The main thing that will come out of this the financial crisis is that you really need these tools and infrastructure in place before a crisis takes place," he says.

More CPR Power

Douglas says he believes that credit and counterparty risk will continue to loom larger in the minds of buy-side and sell-side firms, regardless of the current market turmoil. "The longer term trend will be that credit and the measuring of counterparty risks will be increasingly important," he says.

Buy-side and sell-side firms' increasing focus on measuring counterparty credit risk will provide technologists with significant challenges. Capital markets firms will have to gather more information on levels of risk exposure to counterparties and process it in a shorter amount of time while also distributing the information between credit risk and trading departments. "High-performance computing (HPC) technology is being used to crunch numbers faster. Whereas before a firm's risk exposure would be calculated overnight it is now being done in just one hour," says McPartland.

Capital markets firms are taking a two-fold approach to enhancing the computational power that can be used to power risk management systems: complex calculations are being spread out across multiple processors, while firms are also undertaking initiatives to more efficiently utilize their computing resources. Grid technology-which is already being increasingly utilized by capital markets firms absorbing cutbacks in IT spending-is being used to fulfill more risk management tasks. Instead of running models through Microsoft Excel spreadsheets on local desktops the number crunching is now being done in a grid environment. Server blades in datacenters are also increasingly being shared. McPartland of the Tabb Group says the "cloud computing idea"-where employees book a certain amount of processors for an agreed length of time-is gaining traction among capital markets firms. "This way you get access to what you need to do, such as carry out a report, before the computational resources go back into the pool," he says. "The old way of doing things would be for a couple of servers to be used for two hours and then left idle for the rest of the day." (For more on cloud computing, please turn to page 46.)

Buy-side and sell-side firms specializing in high-speed, high-frequency trading strategies are increasingly incorporating graphics processing unit (GPU) technology to reduce latency. GPUs were originally developed by Santa Clara, Calif.-based Nvidia to support 3D graphics in the computer gaming industry in 1999. The visual computing technology vendor has since launched its Tesla product to provide capital markets firms with high-performance computing solutions that can reduce the latency of risk management applications. "The use of GPUs is still cutting-edge," says McPartland. "The firms that utilize this type of technology do not like to talk about it as they are often quite secretive about their trading strategies." Bulge-bracket sell-side firms, proprietary trading firms and hedge funds are among those believed to be adopting GPU technology in their counterparty credit risk systems.

The use of GPUs can speed up number-crunching tasks such as performing Monte Carlo simulations for the pricing of derivatives. The technology is being used for data storage. For example, in an options contract, multiple data needs to be stored, including its strike price, whether it is a "call" or a "put" and the underlying security the option is linked to. "Different firms store data on options in different ways. GPUs can be used to quickly turn the data into a consistent format in real time, enabling the information to be more easily analyzed," says McPartland. The technology is also being used to enhance and normalize streaming market data before it is transferred to risk models and algorithmic trading engines. The capacity to process data into a consistent format before being incorporated into a front-end trading system is becoming increasingly vital in the risk management processes of buy-side and sell-side firms, which increasingly rely upon different types of data from multiple exchanges and trading platforms.

CDSes GO ELECTRONIC

In October last year the Chicago Mercantile Exchange (CME) and Chicago-based alternative investment firm Citadel Investment Group unveiled plans to set up an independent electronic trading platform for trading CDSes. The platform will function as an electronic exchange for CDS trading, with CME Clearing acting as a central counterparty to guarantee trades. Major CDS market participants have been invited to join the platform as founding members by allocating up to 30 percent of the equity in the venture and committing to becoming market-makers when the platform is launched later this year.

Across the pond, the European Commission is spearheading drives for a centralized clearing model for derivatives instruments such as CDSes. Three exchanges are vying for this business: NYSELiffe, in conjunction with London-based LCH.Clearnet; Frankfurt-based Deutsche Börse's Eurex Clearing; and Atlanta-based IntercontinentalExchange (ICE), which is in talks with UK regulators about allowing its London-based ICE Clear Europe to clear CDSes. Nine of the major dealer firms in the CDS markets have committed to the use of central counterparty clearing for CDSes in Europe by July this year. In a letter sent to EU Commissioner Charlie McCreevy in February, the nine banks-Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS-agreed to work closely with infrastructure providers, regulators and the European Commission to resolve technical, regulatory, legal and practical hurdles. Each firm will make its own choice on which central clearinghouse or houses might best meet its risk management criteria.

A source who works for a trading technology vendor that is providing technology from its core credit risk platform to some of the parties involved in the current bidding war to become a central counterparty for CDSes says market participants are "waking up to the fact that counterparty credit risk is real." The source-who reports a recent increase in demand from insurance companies for credit risk solutions-says: "There will be increasing moves toward a centrally cleared infrastructure for liquid products in the capital markets while more bespoke instruments continue to be traded on a bilateral basis."

The demand among market participants for a centrally cleared model for the trading of credit products is likely to increase as volatile financial markets remain unstable and in uncharted territory, with traditional providers of liquidity such as hedge funds retreating from the market place. These conditions will also result in greater investment in risk management technology as firms try to navigate-and survive-the current market conditions. Developing risk and trading models that provide appropriate levels of protection against the risk of default-while also enabling the firms to profit from the turbulent market terrain-will be vital.

Observers note that this will make latency increasingly important as capital markets firms monitor their trading positions in real time. Few risk managers will be willing to wait until the next day before checking up on exposure to any counterparty, no matter how big the name. After all, no investment firm wants to be the next Lehman Brothers.

 

Source URL: http://www.watersonline.com/public/showPage.html?page=printer_friendly&print=845244

Markit Launches First Multi-Dealer Valuations Platform

Markit, a financial information services company, announced the launch of the first multi-bank, cross-asset client valuations platform.

Markit Valuations Manager provides a secure, standardized view of over-the-counter (OTC) derivative positions and derivative and cash instrument valuations across counterparties on a single electronic platform, according to the company.

Subscribers to Markit's Portfolio Valuations service will be able to view the bank counterparty valuations alongside Markit's independent valuations.

Markit is launching the platform with six banks - Bank of America Merrill Lynch, Citi, Credit Suisse, Goldman Sachs, J.P. Morgan and UBS - and expects to add additional participating banks over the coming months.

The new platform incorporates a dispute mechanism and workflow tools with full audit trail to enhance the price challenge process, Markit said.

The platform is integrated with Markit's Trade Processing PortRec service to enable full life cycle support for OTC derivative positions including counterparty position data delivery. "As an active member of several buy-side working groups in Europe, we welcome the ability to access normalized position and valuation data from the banks in a standardized way. Markit has not only delivered the normalization, but it is it is consolidating the information in a single electronic portal across banks. I think this is a great step forward for the industry," Patrick Finn, Head of Operations at BlueCrest Capital Management LLP in London, said in a release.

Markit says a recent survey it conducted of 50 asset managers highlighted the urgent need for an electronic, secure valuations process.

Portfolio managers currently receive numerous statements from their counterparties in multiple formats, requiring many hours of manual consolidation, the company said.

The survey found that 17% of respondents said that a single file delivery of counterparty statements would save them between 50 and 1,000 hours of work a month. On average, respondents estimated time savings of more than 49 hours a month.

The study also revealed that more complete position information and a standard statement format across all counterparties ranked as the most important improvements required, followed by an efficient price challenge mechanism. Overall, 66% of respondents said they received their counterparty statements by email, underlining the potential security risk of misplaced or incorrectly forwarded emails, Markit said in a release.

Over 65% of respondents said they were under pressure to conduct more frequent reconciliation with counterparties and provide more frequent NAV computation to investors.

Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=214503027

BNY Mellon Debuts Derivatives Collateral Netting Service

The Bank of New York Mellon this week rolled out a new netting service for derivatives dealers called Derivatives Collateral Net. The service uses a technology that, according to BNY Mellon, enables derivatives dealers to post only their net obligations against all other participants in the system, greatly reducing their gross collateral requirements and the risks and costs associated with derivative transactions.

"Derivatives Collateral Net represents the implementation of the International Swaps and Derivative Association's strategic vision for dramatically reducing the operational challenges associated with the margin process between counterparties," said Art Certosimo, executive vice president and head of Broker-Dealer Services at the Bank of New York Mellon. "We're making the process more efficient without affecting the fundamental bilateral nature of the credit relationship between the parties."

"As the global capital markets expand and evolve, our commitment to researching and developing innovative services will provide significant benefits to our clients and strengthen our competitive position around the world," said Kurt Woetzel, chief information officer and senior executive vice president at The Bank of New York Mellon. "Derivatives Collateral Net is the latest example of a new service developed in-house that improves our ability to service our clients."

The Bank of New York Mellon's tri-party collateral management services business services more than $1.8 trillion in tri-party balances worldwide.

Source URL:http://www.wallstreetandtech.com/showArticle.jhtml?articleID=214502079

Cooperation Announced Between Global CDS CCP Regulators

Representatives from regulatory agencies with direct authority over one or more of the existing or proposed credit-default swap central counterparties (CDS CCP) discussed today possible information sharing arrangements and other methods of cooperation within the regulatory community.

Today’s discussion follows an initial meeting held at the Federal Reserve Bank of New York on January 12, 2009. The discussions included representatives from the Federal Reserve, Commodity Futures Trading Commission, U.K. Financial Services Authority, the German Federal Financial Services Authority (BaFin), Deutsche Bundesbank, the New York State Banking Department, the Securities and Exchange Commission, and the European Central Bank and the Hungarian Financial Services Authority in their roles as co-chairs of the joint ESCB-CESR Working Group on Central Counterparties.

The primary objectives of the effort discussed today include:

• Mutually supporting each regulator in carrying out its respective authorities and responsibilities with respect to CDS CCPs; and

• Applying consistent standards and promoting consistent public policy objectives and oversight approaches for all CDS CCPs.

To facilitate communication among the regulatory community with respect to all CDS CCPs, CDS CCP regulators plan to host a workshop in the near future with representatives of other interested regulators and governmental authorities that are currently considering CDS market matters, to discuss the CDS CCP regulatory interests and information needs of other authorities and the market more broadly.

Source URL: http://www.anotherfp.com/newsite/story.php?id=889

CDS dealers bow to pressure and commit to EU clearing counterparty

Nine of the leading dealer firms in the credit default swaps markets have committed to the use of central counterparty clearing for CDS in the European Union by end-July 2009.

In a letter to EU Commissioner Charlie McCreevy, the nine dealers - Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS - have agreed to work closely with infrastructure providers, regulators and the European Commission in resolving outstanding technical, regulatory, legal and practical issues. Each firm will make an individual choice on which central clearing house or houses might best meet its risk management objectives, subject to regulatory approval of any such clearing house in Europe.

The move follows the threat of legislative action by the European Commission after the industry failed to meet an end-December deadline to deliver a detailed plan for CDS clearing in the eurozone.

Last week, London-based LCH.Clearnet announced plans to launch a clearing service for credit default swaps in the Eurozone by December 2009.

The initiative has sparked a flurry of activity in France, where the central bank has called on eurozone countries to come up with an alternative solution to counter the challenge posed by the creation of systemically-significant clearing bodies in London and the US.

In a document seen by the FT, the Banque de France called for the creation of a "consortium of eurozone banks and shareholders of major infrastructures with the objective of developing a common strategy for the integration of several of the eurozone's prinicple clearing houses".

Separately, IntercontinentalExchange, which is looking to set up a global clearing house from the US, has announced plans to set up a European equivalent, dubbed ICE Trust Europe and set a H1 2009 launch date.

 

Source URL: http://www.finextra.com/fullstory.asp?id=19659

Wholesale Market Brokers Association Defends OTC Derivatives Against WFE’s Statement

Association backs central counterparty for clearing, but rejects exchange execution platforms.

The Wholesale Market Brokers Association (WMBA) rebuffed a statement by the World Federation of Stock Exchanges that blamed over-the-counter derivatives markets (OTC) for the recent financial crisis. The statement reported in press coverage said that "unregulated (OTC) markets were at the core of the recent crisis and that OTC markets are unregulated," according to the WMBA.

The WMBA, representing the world's largest interdealer brokers contends the crisis is the result of "several seismic economic and financial forces." WMBA attributes the crisis to the transformation of bank lending into highly complex credit products, that originators, rating agencies, buyers, and sellers of protection found difficult to value correctly, find liquidity for, or to hedge, according to WMBA's statement.

Refuting the perception that the OTC derivatives markets are unregulated, WMBA said the primary regulatory focus in OTC markets is on the participants themselves based on their activity, the nature of counterparties and types of assets involved. According to WMBA, it is misleading to suggest that exchange traded markets have a more robust regulatory model. There are still instances of failure in the exchange- traded model, it points out, implying that individuals or organizations should be the focus of supervision.

Instead, there is a danger that policy decisions are being made that could force OTC products onto exchanges, resulting in a dramatic reduction in liquidity and flexibility in markets essential for trading and hedging. WMBA contends that OTC markets are more appropriate for hedging non-standardized risks. It pointed out that billions of Euros of OTC trades are currently centrally cleared on a daily basis, adding there should be no confusion

However, WMBA supports the move towards a central counterparty (CCP) as an effective step to improve the settlement of credit default swaps and other OTC products generally. Acknowledging that there will be regulatory changes as a response to the crisis, WMBA insists the focus should be on" regulation of participants and not on mandating of monopolies in the execution of financial products."

Source URL: http://www.financetech.com/showArticle.jhtml?articleID=214501800

Risk Management Evolves for Risky Times

As the new presidential administration and regulators continue to try to pick up the pieces of the shattered U.S. economy, the heat is on financial institutions to make sure their risk management practices are fully aligned with rapidly changing economic and market conditions. For most Wall Street firms, this means a growing demand for real-time systems, particularly for the valuation of securities, and increased automation, according to experts.

"Whether you're a business or a regulator, I wouldn't be surprised if in the near term more real-time systems are brought into play," says John Jay, a senior analyst with Boston-based Aite Group. "People before weren't paying attention. Now, knowing implosions have occurred, they're moving forward, and the trend is toward real time."

And with so much information flowing so quickly, automation is a key component of any risk management strategy. "If firms have significant assets, they would be foolish to still be using spreadsheets," Jay asserts.

"Size is an issue," he continues. "Over the past few years values have come down, but maybe the line items are still there. So for a lot of sell-side companies that are buying and selling all day long, particularly with over-the-counter derivatives, they might have tens of thousands of line items. And that's just a small portion of their business. So to have a spreadsheet would be rather dangerous."

As recently as a year ago, with the credit crunch and financial crisis looming, many firms relied on reactive and manual processes, confirms Dave Stewart, director of risk solutions for Misys and global solutions manager for the vendor's Misys Opics Plus front-to-back-office multi-asset-class processing platform. "They needed to put data in a spreadsheet, do analysis, get information to be aware of their positions of risk and have a bunch of metrics to enable them to make decisions for business," he says. "That type of practice has not been very effective. That practice doesn't give them the level of transparency or visibility to make the right decisions."

To avoid the kind of systemic meltdown that caused the financial crisis in the first place, companies need much better access to information in real time, Stewart stresses. "A lot of how they monitor their business can be improved dramatically if they have the ability to be aware of what's going on in a more holistic and real-time manner," he comments.

Finding a Good Value

One of the main issues financial firms are facing today is valuing their over-the-counter derivatives, according to Robert Park, CEO of FINCAD, a Surrey, British Columbia-based provider of derivatives analytics tools, who says firms increasingly are interested in getting independent valuations of derivatives positions. "Most of the assets being traded are Level 2 instruments for which there is no market quote available," Park explains. "So getting an independent valuation is one of the key concerns in the marketplace today."

Reliance on valuation models also is greater than in the past, adds Jason Hahn, SVP of market risk management for the mortgage lending division at BB&T Corp., a Winston-Salem, N.C.-based financial holding company with $137 billion in assets. But the models face their own challenges, he notes.

"A lot of people have taken the stance that fair-value accounting has been detrimental to the financial system's stability," Hahn relates, referring to the mark-to-market practice of valuing financial instruments using available market prices. "To do that in cases where the instruments are really easily tracked is good, but for more-esoteric instruments, some market value might be available for a benchmark, but you also need to have financial models that allow you to translate the benchmark to your simple calculation."

Further, many valuation models do not consider counterparty risk, points out Tom Driscoll, VP, sales and marketing, Charles River Development. "Institutions once deemed quite solid are not," he observes. "That puts pressure on flexibility and the models to make assumptions that a year or two ago would have been quite outrageous but, given the current situation, are likely a much greater risk now. That counterparty risk and how valuations are done need to be more flexible." He adds, "There's a lot of pressure for firms to not use a standard model to look at risk and valuation."

Ultimately, however, the financial analytics software itself shouldn't change all that much, suggests BB&T's Hahn. Rather, it is how the software is used -- what kinds of numbers are fed into it -- that will change. "Do you feed market data that is current, or a historical-average number?" Hahn poses. "Perhaps how you use the model might change -- the role that a model value has compared to market value, and how you go about reporting that."

Adapting Models to New Regulations

Another variable in Wall Street's risk models is emerging regulations, notes Aite's Jay. "Change is upon firms whether they like it or not -- not only internally but with regulations, too," he points out.

As a result, stress-testing systems -- not just for extreme market conditions but also for regulatory scenarios -- are becoming increasingly important. "In more-robust systems, we will see some of these compliance tools incorporate randomly generated scenarios subjected to constraints," Jay predicts.

"But what some systems may or may not capture is ... the effect of compliance if such a scenario came into play," he continues. "So if you're just looking at economics over a scenario, the economics might work and come up with a number. But you may also be violating liquidity constraints."

The bottom line, then, is that executives need to understand their own risk systems and what those systems are trying to say, Jay asserts. This is crucial when faced, for example, with rogue traders who have a lot to gain if they are successful and stand to lose little if they are caught, such as Jerome Kerviel, the former Societe Generale trader who was responsible for a $7 billion loss at the French bank by circumventing the risk management system.

"As far as risk managers are concerned and very senior guys, they need to understand from a compliance perspective the little loopholes but also the analytics, and understand what those risk management systems are telling them, and what they're not telling them," says Jay. "A senior officer ... now has to go beyond [trading volume] and see what his concentration and exposure is, [trades] on the books, those that are about to settle or will in the future, who the counterparties are, and whether some have incorporated regulatory requirements."

No Escaping Accountability

Overall, the key issue for everyone -- right up to a company's senior officials -- is to truly understand the instruments that are being traded, asserts Aite's Jay. "[Madoff whistle-blower] Harry Markopolos said the SEC was asleep at the wheel," Jay notes. "He said regulators don't understand the financial instruments. But that could be said for a lot of executives at buy-side and sell-side firms."

That lack of understanding, Misys' Stewart adds, contributed to organizations extending their risk exposure. Too often, he suggests, those who should have been accountable for their firms' positions weren't aware of the level of risk involved in certain holdings.

"It's one thing to be in business and make your assets under management grow, but another to not be held accountable to what they are," says Aite's Jay. "There has to be an increased knowledge base from senior folks. You can't get a free pass anymore by saying, 'Our risk people are dealing with that.' "

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