The Risk Analytics Library: Time For A Single Source of Truth

The Risk Analytics Library:
Time for a Single Source of Truth

As the tail of post-Global Financial Crisis (GFC) reverberations stretches further into the future, the magnitude of regulation-induced impacts on the largest banks and asset managers continues to be unclear and largely unquantifiable. Despite this uncertainty, one thing is certain: Sins of the past are rising to the surface, and two in particular are cause for a major rethink of the best practice approach to effective risk management and the necessity for supporting platform architecture that achieves much more timely, accurate and comprehensive risk measurement. First, credit risk is currently upstaging market risk as the priority focal point for risk measurement. It needs to become a core and enterprise-wide competency. However, since the practice of credit valuation adjustment (CVA) is mainly found in the pricing of OTC deriv atives, such an enterprise functionality rarely is found in most firms, particularly on the buy side. This needs to change, and fast. Second, though an unintended sin, tolerance of technical fragmentation over the years has led to far too much complexity a nd far too many versions of output. This also needs to change as fast as an organization can move. The sooner folks can sing from the same song sheet when it comes to a unified view of risk, the better off individual firms and the broader financial ecosystem will be. TABB Group believes that an effective component of the platform used t o satisfy these critical needs is a central, multiasset library of risk analytics from which everyone in a firm can draw. E. Paul Rowady, Jr. V11:015 April 2013 www.tabbgroup.com
The Risk Analytics Library: Time for a Single Source of Truth | April 2013
Introduction
Having reached its apex around 2007, t he capital markets pendulum is swinging back, changing course and retracing its arc of the past three decades. The following chain of events, which began with the GFC, and which is being perpetuated by the mass and unprecedented regulatory (and interventionist) response to this crisis, will continue to see challenges to business growth, continued resource constraints in nearly all corners, and, ultimately, major shifts and reconfigurations in capital markets business models. In turn, these shifts will require new technology strategies where capabilities are right-sized for new regulation-induced transparency and competitive requirements and costs are right-sized to the new scale and profit expectations of opportunities. Do not be fooled by strength in stock markets, because they are not indicative of the magnitude and permanence of the underlying shifts in the broader capital markets landscape. Across all asset classes, market structure, trading costs and demographics are collectively in the process of unprecedented transformation. As this transformation continues, unintended sins of the past will keep showing up like reefs in a receding tide at the precise moment that the market ecosystem can least afford it. Meanwhile, the performance requirements for enterprise data management (EDM), coupled with a much broader spectrum of risk-related analytics (extensively covering market, credit , liquidity and operational risks), have never been greater. How to do much more with far less is going to remain a mantra for the Exhibit 1: foreseeable future. Data- and risk-related Risk System Spending A Rare Bright Spot upgrades will determine the survivors. As a result, there will be ongoing budgetary air cover for such improvements that can be justified under the guise of regulatory and compliance initiatives. For now, ongoing investments in risk analytics and underlying data management functionality continue to grow, bucking the trend of resource constraints in all other corners of the organization. TABB Group estimates that of the top 15 sell-side IT spending categories, only pricing/reference data and risk management are areas of expected growth in spending for 2013 (see Source: TABB Group Exhibit 1). Furthermore, TABB Group believes that this general trend is likely to persist over the course of the next 3-5 years. Moreover, for the buy side, the outlook is even more pronounced, since buy-side firms have historically lagged the sell side in their proportion of IT spend on risk analytics solutions. If the gap between the buy side and sell side widens even further, the disparity between the two will become a risk of its own. Lastly, TABB Group believes that risk and data-related spending needs to be targeted at overcoming past flaws in risk measurement strategy, which can generally be described as
2 0 13 The TABB G roup, L L C. A ll Rights Reserved. M ay not be reproduc ed by any means without express permission. |
capability gaps and complexity costs . For capability gaps, credit and liquidity risk analytics stand out as an area that has remained significantly underdeveloped from an enterprise point of view. For complexity costs, technical fragmentation and other impediments to the creation of unified and enterprise views for risk also need focused attention.
The Golden Age of Credit Risk

Many close observers of the OTC derivatives (OTCDs) markets during the post -GFC era have been operating under the assumption that , with all exposures presumed to be going to central clearing and remaining bilateral exposures eventually dying on the vine due to higher costs the importance of topics such as CVAs would wane significantly. After all, many of those who sit on so-called CVA desks at major dealing banks have recently commented that the vast majority of their activity something on the order of 85% is related to pricing of bilateral, non-cleared OTCDs. Upon closer analysis, it turns out that CVA is not going to wane in importance for a long time. In fact, in the four-legged risk stool where the legs are broadly represented by market, credit, liquidity and operational risks credit risk has made a resounding move to center stage over the past 2 years. Fast approac hing milestones within the global regulatory transformation are the primary driver of this focus on counterparty credit risk. TABB Group recently estimated that 55% of the approximately $670 trillion in global notional value in OTCDs (as of February 2013) are being cleared (across all asset classes), with 5% categorized as clearly unclearable and the remaining exposures some 40% designated as potentially clearable. With currently cleared structures limited to only vanilla swaps (i.e., fixed-vs.-floating), basis swaps, overnight index swaps (OIS), and forward rate agreements (FRAs), the uncleared components consist of a mix of trade structures that include one or more of the Exhibit 2: following core attributes: client-side (or OTCD Rates - Clearing Segmentation Estimates D2C), non-linear, illiquid currencies, and/or (February 8, 2013) otherwise exotic . Available for Potentially Clearly
<<<< Cleared >>>>
Clearing
Clearable
Unclearable
Using trade repository data specifically for interest rates derivatives from the Depository Trust and Clearing Corporation (DTCC) as of February 8, 2013, TABB Group is able to enhance its estimates, as follows: 58.5% (of OTCD rates exposures) are cleared, 29.3% are available to be cleared (i.e., mainly client-todealer, or D2C); and the remaining 12.2% are potentially clearable or clearly unclearable, in both dealer-to-dealer (D2D) and D2C categories (see Exhibit 2).
?
No Hedge
?
58.5%
?
29.3%
?
12.2%
Global Risk Transfer Market (GRTM) - Product Spectrum

<<<<<<<< Vanillas >>>>>>>> Semi -Exotics Exotics
Battlegrounds <<<< ETDs >>>> <<<< Futures Hybrids Options Cash OTCDs >>>>
Estimate of notional outstanding in current OTCD Rates clearability segments
Source: TABB Group, DTCC, BI S
The objective of a more detailed estimate and segmentation of exposures is to illustrate just how the remaining 12.2% or, a very large $65.8 trillion is set to remain on the books of systemically important financial intermediaries (SIFIs) for the foreseeable future (see Exhibit 3).
Exhibit 3 Persistence of Exotics
Source: TABB Group, DTCC
Here is the bottom line for this part of the analysis: Unless these exposures are novated or otherwise terminated and without making any assumptions or assertions about the creation of new unclearable trades at least some tens of trillions of dollars of notional values will remain in the system for two decades. For instance, nearly $6 trillion of mainly swaption exposures have durations of 30 years or more. As a result, each counterparty in the vast tapestry of nearly $66 trillion in unclearable exposures will need and in most cases, be required to implement the ability to assess the risks associated with these positions for years to come. In short, one could argue that credit risk and pricing factors such as CVA have never been more important than they are right now. But the CVA story doesnt stop there. Credit value adjustments have the potential to be embedded into the pricing of all counterparty relationships going forward, such as prime brokerage and financings for hedge funds, or concentration of exposures with all kinds of counterparties, such as CCPs. Moreover, there is little or no parallel to this story on the buy side, where there has traditionally been no need to price the counterparty risk in anything other than holdings in stocks or bonds. Now the pricing of counterparty risk is everywhere, in all types of transactions.
At the end of the day, it turns out that the skeptics of CVA couldnt have been more wrong. Clearing doesnt even matter in the context of reducing bilateral exposures. In an increasingly resource-constrained and deleveraging environment, embedding the price of counterparty credit risk into all transactions has never been more important. In many ways, we are entering a golden age of credit risk analysis and not the other way around. For those that have been actively engaged in the swaps markets, the importance of credit risk and CVA is nothing new. The fact that it has become so mainstream, however, is quite new it is now on both sides of the proverbial Street . Now add the impact of liquidity analysis on the calculation of margin requirements and consider that much of the capability to perform these tasks is not even in place today. For instance, in a study conducted by the EDM Council in 2011, 60% of data management program drivers were related to risk, compliance and regulations; however, only a small percentage of expected functionality as low as 8% for leverage and funding risk had been implemented at that time (for large and medium-size players), leaving significant work yet to be done. TABB Group estimates that there are 350-400 large financial intermediaries, including dealing banks, super-regional banks, asset managers, and hedge funds, as well as a few utility players (such as CCPs), that make up the vast majority of exposures in the global capital markets. It is this community of participants that is the most intensely focused on credit, counterparty and liquidity-related risks. And although these concerns and needs certainly penetrate further into the spectrum of mid-size and smaller players, it is the largest and most complex firms that can benefit most from an enterprise risk analytics library.
Complexity of Technical Fragmentation

Technical fragmentation represents another significant source of impediments to enterprise visibility and timeliness of risk analytics. As a result, streamlining, consolidating and thoughtfully centralizing risk measurement capabilities is of critic al importance to right-size costs and performance requirements for the road ahead. There are three sources of technical complexity that central libraries can help solve. These include: 1) Elastic Fragmentation: Cultural tolerance for and/or policies that allow broad latitude for solution choices even for the same or similar purposes. 2) Legacy Fragmentation: Accumulation of similar solutions or versions of solutions, some of which are tied to outdated technology, old rules and former clients over a long period of time. 3) Transactional Fragmentation: Accumulation of redundant solutions and functionality as a result of mergers, acquisitions and other business combinations .
Large sell-side firms are most likely to suffer from each of these forms of technical complexity, as well as the second-order complexities caused by the combinations and permutations of these. On the buy side, the transactional and legacy fragmentation complexities are less prevalent, with the exception of the largest and most established players. In both cases, elastic fragmentation has been the result of nearly t hree decades of consistent market development, financial product innovation and high profitability . These were among the most consistent excuses for technological elasticity and fragmentation. For the sake of expediency (and due to the lack of standards), maximum flexibility in the choices of systems and architectures was tolerated. In many ways, internal competition was promoted and supported to weed the garden of mediocre performers. With internal competition came the latitude to choose, if not for any other reason than each performer (each desk or business unit) was granted protection of its special sauce with high degrees of latitude to choose a toolkit. The front office was the poster child for this phenomenon. Going forward, commitment to the benefits of internal competition will need to be limited to the use of tools and not the choice of tools. Overall, the complexity of technical fragmentation is a lose-lose situation in the short term. It takes a lot of effort to maintain it , and it takes a lot of effort to change it. However, the upside to changing it and changing it with an eye toward future proofing is that performance and operational alpha are enhanced. Maintaining complexity becomes more expensive as the utility of the underlying framework decays. Since current monolithic architectures have proven ineffective and cumbersome in achieving the new risk and reporting performance requirements, market forces are highlighting that a new approach is desperately needed. We are at the tipping point of technical innovation in the development of centralized, enterprise risk analytics libraries.
Digital Libraries
Raw computational functionality is not the primary impediment to meeting the requirements of the new regulatory regime. The challenge is the massive integration of systems and aggregation of data necessary to foster data fluency . Most of the 350-400 largest financial institutions need to simultaneously consolidate numerous legacy systems and move post-trade data to the front office for enhanced pre-trade decision support (see Exhibit 4, next page). Otherwise, they have no chance to accomplish the functionality objectives for credit analysis, collateral management and capital controls in the required timeframe. The backbone of all of these metrics is the same or similar. There is a significant data challenge hence the focus on integration and aggregation. Suddenly, firms need to consolidate positions across dozens or hundreds of desks across the enterprise (which often spans the globe) and harmonize the metrics. Firms need to bring in data from multiple internal sources: legal, collateral, credit risk and liquidity models. Only then can simulations, stress tests and other what-if scenarios can be run with confidence.
And then the output from these analyses need to be harmonized and managed. This is all a huge but necessary shift that can be dramatically simplified, in part, by creating a central store for analytics (see Exhibit 4).
Exhibits 4 and 5 Shifting Toward Centralized Libraries
Source: TABB Group
And though it is yet to become a ubiquitous requirement today, speed of computation of risk sensitivities will enter the equation on the back of many of the regulatory mandates which means very soon. Today, some firms are measuring risk only once per week which, if you are an active hedging firm, borders on negligence. Once-per-week to daily to intraday to real time is a huge series of leaps, with massive architectural implications. Although there are techniques to cut corners by calculating some inputs at lower frequencies, this is still a monumental industry-wide aggregation project. Getting hundreds, if not thousands, of systems to speak to one another is unprecedented. Most systems wont make the cut, and because of this, some of the larger firms wont make the cut either. Taking the hard road toward simplification and unification sooner rather than later will pay big dividends. Lastly, a central library of analytics does not suggest that an individual or business unit will lose its ability to customize its views of risk. Though internal competition (which allows for greater latitude in choosing solutions) definitely needs to be reduced in the new paradigm, we are not here to suggest that everyone at the same shop adopt the same modeling o f risk. Consistent firm-wide views of risk metrics is the goal. Having them with an option to customize is a much more sound practice than not having them and pretending otherwise.
Conclusion
In a former chapter of capital markets history, maximum flexibility was (believed to be) needed at the desk level due to the rapid, on-the-fly nature of product innovation. However, the unintentional sins of this approach are now coming loose from their cement shoes, floating to the surface, and requiring critical attention at precisely the time when resources are becoming increasingly scarce. Capability gaps and complexity costs can no longer be ignored or papered over. As a result, the most complex capital markets firms are typically among the first to acknowledge the need for a series of more centralized stores of enterprise intelligence, or libraries. As product, process and other standards proliferate and become more mature, the barriers to creating such centralized libraries are dramatically reduced. TABB Group believes that some of the best examples of these might include a meta-data library (a source from which all primitive, organizational data is cat egorized); a project, task or functionality library (a source from which all application or applet functionality is stored and catalogued); and an analytics library (a source from which all risk calculations can be organized). Moreover, the cloud/app architecture forces a rethink of enterprise risk architecture around an integrated analytic platform a platform that includes the cross-asset library but also the compute and memory scalability, rapid application development (RAD) tools, primitives for securities data, counterparty data, credit support annex (CSA) information, and realtime business intelligence/visualization functionality. Ignoring the need to rethink business models and right-sizing technical architecture (in part , through consolidation, simplification and centralization) is tantamount to sticking ones head in the sand. Yes, market transformation can be painful. Ultimately, some business units may need to be jettisoned, others forced into protective custody with other business units, and still others that will be dramatically overhauled receiving deep makeovers and all of the above will need to be done much more efficiently in terms of resource allocations, time and personnel. Yesterdays s hould-haves are now becoming todays must -haves. At the base of it, risk is simply the absence of certainty: Know an outcome in advance, no risk. However, the simplicity ends right there in the words. There really never is any certainty as much as we might like to pretend otherwise from time to time. The best consolation prize for a persistent absence of certainty can be only the pursuit of everimproved clarity. However, technical fragmentation, layers of complexity, and asymmetric clarity are not a sufficient proxy for full enterprise clarity. In fact, TABB Group believes that timely enterprise clarity with less accuracy trumps isolated and episodic clarity with higher accuracy every time because its always the stuff in the dark that gets you in trouble. The days of each desk or group picking its own systems and vendors are over. In order to develop a unified view of risk throughout the organization, an integrated platform with a centralized multi-asset risk analytics library will need to be put in place. Whether folks realize this, and how to accomplish such a huge task, is no longer a story for another day. The time for a resurgence of libraries is precisely right now.
About
TABB Group
TABB Group is a financial markets research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the methodology of first-person knowledge, TABB Group analyzes and quantifies the investing value chain, from the fiduciary and investment manager, to the broker, exchange, and custodian. Our goal is to help senior business leaders gain a truer understanding of financial markets issues and trends so they can grow their businesses. TABB Group members are regularly cited in the press and speak at industry conferences. For more information about TABB Group, visit www.tabbgroup.com.
The Author
E. Paul Rowady, Jr.
E. Paul Rowady Jr., a senior analyst at TABB Group since early 2009, has more than 22 years of capital markets, proprietary trading and hedge fund experience , with a background in strategy research, risk management and technology development. He also has specific expertise in derivatives, highly automated trading systems, and enterprise data management initiatives. Rowady earned a Master of Management from the J. L. Kellogg Graduate School of Management at Northwestern University and a B.S. in Business Administration from Valparaiso University. At TABB, Mr. Rowady has authored Many Shades of Vanilla: The Increasing Complexity of Hedging; The New Global Risk Transfer Market: Transformation and the Status Quo; Reference Data Management: The Key to Operational Efficiencies; Real- Time Market Data: Circus of the Absurd; An Agency Brokerage Model for Swaps: Evolution of Liquidity Access; Initial Margin for OTC Derivatives: The Burden of Opportunity Costs; Quantitative Research: The World After High- Speed Saturation; Interest Rate Derivatives 2011: Collateral Damage i n the Duration Market; The Global Risk Transfer Market: Developments in OTC and Exchange -Traded Derivatives; Trading in Asian Derivatives: Opportunities Near and Far; Global Markets on Demand: Unified Infrastructure Required; OTC Interest Rate Swap s and Beyond: The Path to Electronic Markets and US Futures Markets: In the Crosshairs of the Algorithmic Revolution. He also has co- authored (Hedge) Fund Administration: The Selection Criteria for a New Market Reality; The Investment Assembly Line: Alpha Discovery and the Illusion of Automation and Risk Analysis On-the- Fly: Fast Markets, Complex Portfolios.
www.tabbgroup.com New York + 1.646.722.7800 Westborough, MA + 1.508.836.2031 London + 44 (0) 203 207 9397

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The Risk Analytics Library:

Time for a Single Source of Truth

The Golden Age of Credit Risk

Global Risk Transfer Market (GRTM) - Product Spectrum

Source: TABB Group, DTCC, BI S

Source: TABB Group, DTCC

Complexity of Technical Fragmentation

Source: TABB Group

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