Risk Management:

Crisis Makes Interoperable Systems a Priority, Marking Need for Unified Field Theory of Risk

Originally published May 12, 2008

NEW YORK — As the securities and investment industry braces for the challenges of recovering from the sub-prime mortgage crisis, an important pathway to restoring normalcy may lie in re-defining interactions between lines of business as well as developing systems interoperability. The fallout and lessons of the debacle set the stage for a unified field theory of risk management, giving early adopters a competitive advantage.

“The top business driver [now] is economic, market and regulatory volatility,” says Guillermo Kopp, Vice President, Financial Services, TowerGroup. “The strategic responses have risk management at their heart. [Firms] also talk about restructuring operations, which is selling assets and re-defining the interplay between the lines of business.

“Between liquidity, markets and credit, and the information on a security and access to the market center, an integrated approach to risk is needed across business lines, product allocations and the convergence of financial performance and controls,” he adds.

As part of interoperability, firms should look at transparency, says Neil Edelstein, Vice President of Solutions at GoldenSource Corporation, an enterprise data management services provider with offices in New York and London. “Typically, trading desks are set up or have historically been based on asset classes,” he says. “That adds value, but as we see deals structured with increasing complexity, there are cross-asset class structures that are really gaining popularity.

This can be an enterprise measure in different ways. It’s important that the entire organization have a singular view of data. But it’s equally important when any security that is structured from another security or links to other securities, that the links are understood and transparent to the players in those asset classes — and ultimately to the institutional and retail markets that they serve.”

Achieving such transparency and interoperability for a range of asset classes can be a challenge when using “shrink-wrapped” solutions, according to Edward L. Bishop III, Chief Executive Officer of Kestrel Technologies, a fixed-income trading and research, portfolio management, risk management and connectivity solutions provider. “There are a number of systems used by players that typically do plain vanilla [securities],” he says. “That’s perfectly O.K. for corporate bonds and junk bonds, futures and options and the like. But in sub-prime mortgage lending, the associated packaging and securitization of the product outstripped the ability of the major firms to build their own systems.”

Financial firms are becoming more interested in an integrated approach to managing risk that encompasses various asset classes, according to Priya Bajora, Senior Engagement Manager, Banking and Capital Markets, at Infosys Technologies Ltd., a global business solutions provider and consultancy with more than $4 billion in revenues.

“Whether it’s operational risk, credit risk, market risk or interest-rate risk, they are looking at it more wholistically,” she says. “Operational risk is generating a lot of interest, which involves looking at the business processes, underlining what could be the potential break-points in those processes, where the most likely points of failure or loss are, doing analysis of those, setting up controls around those areas and then measuring accordingly.”

Firms that have already moved in such an integrated direction are finding it a competitive differentiator, explains Bajora. “It shows their customers that they have a better handle on the overall situation,” she says. “There is a lot of technology investment being made to figure out the best venue for routing an order, including low-latency trading, in-memory processing, and reducing the time taken to route the order and fulfill it. Firms are looking more at the latest systems for pre-trade compliance, ensuring that technology is keeping pace with the trading technology, because if pre-trade compliance checks take more time, they lose a window of opportunity for trading. The focus is putting adequate blocks and controls on systems without impacting their performance.”

As financial crises typically start with one issue and reach into others,  aspects of all realms play a part in a turnaround, notes Edelstein of GoldenSource. “It’s incumbent on the marketplace now to open up the kimono on securities and liquidity transparency,” he says. “In some ways it’s a marketing issue, in some ways it’s a basic security and collateral issue. Once you address one area, you address them all. We see this even in the ratings agencies, which are a core component of this. They’re attempting to get in front of the curve to provide solid financial and demographic explanations for ratings policies.”

The SEC is also beginning to step in with comment on derivatives valuation practices and derivatives organizations are working on ways to standardize necessary data which can be made transparent to the public. The industry is, in effect, searching for a stochastic or random, risk management process that can capture that stochastic nature of an event like the sub-prime crisis, “where you’re O.K., then suddenly, bingo, you’re not,” says Bishop of Kestrel Technologies. “We have to find out what’s likely to bring that discontinuity into play.”

Risk management models have to be constructed to address such “extreme” scenarios, stresses Bajoria of Infosys. “We have been doing a lot of engagements specifically around independent valuation or testing,” she says. “As we build out scenarios, it has become very apparent that liquidity in the market can impact a scenario. So it becomes necessary to test the model under extreme circumstances and simulate those conditions up front while doing the development before businesses even use it. Risk managers are getting involved in testing scenarios.”

In particular, “tail” events in value at risk scenarios are important in testing, notes Bajoria. “If the market is falling into the extreme scenarios, you better make sure that your model will hold for that. That becomes all the more relevant when there’s increased reliance on algorithmic trading. When you’re trading so much electronically, and all those models are built in, it’s becoming that much more important to bring in the risk manager while you form the algorithms and make sure they agree with the parameters the system will pick up when it runs these algorithms in real time.”

In some cases, technology is catching up to the need to integrate across business lines and asset classes, according to John Pfuhler, Director of Product Management for Reconciliation and Exception Management at Checkfree Corporation, a provider of financial electronic commerce services and products acquired by financial technology solutions provider Fiserv Inc. in 2007. “The mindset of the financial services industry needs to mature a little,” says Pfuhler.

“Reconciliation and exception management are cornerstone components of that type of bigger-picture vision. These are functions that every financial services organization needs as part of their post-settlement processing. They have to ensure that what they expected actually happened in the settlement process. They’re looking for potential failures that could be accidental or deliberate fraud. This all rolls into operational risk — identifying transaction failure are a key component of operational risk [management]. Once identified, how quickly you can manage and resolve those exceptions also plays a critical role in measuring and quantifying operational risk.”

In particular, interplay between credit and trading operations requires attention, according to Kopp of TowerGroup. “In the capital markets arena, securitized assets such as collateralized debt obligations with underlying mortgage debt, including sub-prime debt, were sold or traded under procedures through open markets exchanges of securities and derivatives — by asset managers selling them mostly to institutional investors,” he says. Market participants “liked the yields and returns of those securities. They seemed secure because they were spread out over the growth base. [The market] trusted traders selling those because banks, financial services firms and brokers had security procedures in place.”

Disconnection between credit and trading operations, or credit and liquidity, exacerbated the sub-prime crisis to begin with, observes Kopp. “The credit and trading markets tend to take different routes,” he says. “The calculation of credit risk allows mortgages to proceed. The calculation of market risk allows liquidity and investments to proceed at an even higher speed. With a shortfall in liquidity due to write-downs, when the crunch came, the consequences were in the billions of dollars.” The silver lining is that it sets the stage for next-generation technologies that can unify risk management systems and processes to capture a total, global picture of all assets in real time, as well as help predict the consequences of a random event on risk exposures.

   
     

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