Lessons for Risk Management - Wilmott and Rowe

Great event organised by PRMIA and IAFE last night at Goldman's London offices with a long title:

 "A Little Thought Goes A Long Way and Lessons for Risk Management from the Current Crisis".

The event was moderated by Giovanni Bellossi of FGS Capital, and featured speaking slots by Paul Wilmott and David Rowe of Sungard. Here are my notes on the evening, please forgive any innaccuracies, and please persevere through some of the techy quant stuff, as their general points are well worth understanding.

• Giovanni quoted from Nassim Taleb about how VAR is invalid and that mainstream financial mathematics should be banned (or words to that effect, see earlier post on Taleb)

• He added that whilst what Taleb says cannot be ignored, he said that despite the current crisis and its causes that we should not "throw the baby out with the bathwater" and added that Taleb "...is not only able to recognise a cow but also knows how to milk one."

• Giovanni said that financial mathematics has much to offer and that whilst VAR is simply a number, one of its great benefits has to make one measure of risk simple and compelling enough to get traders and risk managers talking.

Paul Wilmott then took the floor and put forward his thoughts:

On Taleb and the Black-Scholes Model

• Paul mentioned that he and Taleb were great friends, and whilst he agreed with much of what Taleb says he has areas of disagreement, particularly over the use of the Gaussian distribution in finance and its implications for "fat tail" events
• Paul Googled "Taleb" and found more entries for Taleb than for Stephen Hawkin which shows how much attention had come his way due to the "Black Swan" debate
• He thinks that he and Taleb are the "Marmite of finance" (for those of you not in the UK who do not know Marmite, it is a sandwich spread that you either love or hate, never anything inbetween)
• He suggested that every quant needs a much more fundamental and practically grounded understanding of financial mathematics.
• Paul refered to some work (mentioned by Giovanni) that Peter Carr of Bloomberg had done on discrete daily hedging that showed that this option replication technique could remove up to 85% of the risk and that all quants should know about this 15% error term when trying to calculate an option price to the Nth decimal place.
• He described how in the past he had set up a volatility arbitrage hedge fund, wanting to improve upon the flawed assumption of the Black-Scholes (B-S) model that volatility is constant and to build the world's best volatility model for option pricing.
• Paul said that he did build the world's best volatility model (?!), but soon found it took too long to calculate, so he reverted back to B-S and has become an unfashionable fan of the model and its assumptions.
• He added that many of the variants on B-S to overcome its limitations have made the model worse and harder to calibrate.
• In some part due to Taleb's opinions on fat tails of distributions, B-S and other models are now very unpopular but Paul claims that not many people have actually bothered to robustly test the B-S model or take a practical, evidence based approach such as that adopted by Peter Carr.

• Paul then showed some example charts and said that with a limited number of opportunities for regular time-period hedging it was not valid to use risk-neutral pricing whereas if the same number of hedges could be used optimally (implying at irregular time periods) then risk-neutral was valid and hedging could be more effective. He emphasised that this was the kind of practical stuff that a quant should know and that quants show know less about esoteric complex financial mathematics.

Correlation

• Paul said that of all of the issues that need addressing in mathematical finance, the one that he has very few answers on is correlation.
• He showed that even basic questions about correlation are poorly understood, even by quants - a question he asks some quants was that if two asset prices both start out at 100, and they have a correlation (of returns) of 1 (perfect correlation) what is the price of the second asset after a year if the first moves to 200. The answer is not 200, and he showed how assets could diverge in overall direction but still have a correlation of 1 or rise together with a perfect negative correlation of -1.
• Paul illustrated how correlation was a very blunt measure that is mis-used by people to summarise the highly complex and historically unstable relationships between assets driven for example by industry sector success (leading to +ve correlation) or competitive success (leading to -ve correlation)
• As a result, he said that financial products whose value depends on correlation should not be transacted in any great size and moved on to the example of CDOs, where a CDO with 1,000 underlying mortgages has been modelled with 1/2 million correlations all assumed to be 0.6. Why this assumption should be made was his main point.

Sensitivity to Parameters

• His main point here was that a constant should not be varied, otherwise it is not a "constant", in particular focussing on volatility used in the B-S model and the calculation of Vega as prices are moving.
• Paul added that sensitivity measures may apply locally and is such may look comparible from one situation to another, but quants need to understand how outputs respond over a wider range of inputs, and not to be inhibited by accepted practices and beliefs.

Complexity

• Models need to be robust and transparent, and that quants should aim for the mathematical sweet spot.
• Paul put forward the following analogy that at least when driving an old car over a long distance, you knew that the car was likely to break down at least once, but you also knew that it was likely that you could fix it. Contrast this with driving a modern sports supercar and finding that it has (unexpectedly?) broken down - you don't know how to fix it, you do not complete your journey and it costs you an ordinate amount of money to put things right...

Self-Referential Feedback

• Paul described here how the hedging of derivatives contracts in the underlying markets can cause price movements in underlying markets that cause derivatives contracts to re-price that cause more hedging in the underlying markets...
• He was critical of credit derivative pricing as being too complex and too "mathsy" (...but had to admit that he had also endorsed some of this work at the time)

Calibration

• Paul said that model parameter calibration is the devil's work...
• He refered us to inverse problems in mathematics as a background to this issue in mathematical finance.
• He emphasised how markets and price behaviour is fickle and driven by human opinions and behaviours
• He said that on-going and regular re-calibration of a model is very, very likely to mean that the model is wrong (he had a particular example of calibrating a particular model he hates where vol is a function of underlying price and time.

David Rowe, Sungard's specialist spokesman on risk management, then took over from Paul and set out his five topics for discussion:

• Statistical Entropy - fundamentally that information can only be extracted from data, with the emphasis on extraction of information (from that already in the data) rather than creation of new information.
• Structural Imagination - that we need to be aware of how the market assumptions we make are themselves a model and that we need to spend more time on thinking about what could happen outside our current understanding or market experience.
• Self-Referential Feedback - the feedback loops in pricing, risk management and economics
• Complexity and Dark Risk - when you add (untested) complexity of a model to limited data sets you get a recipe for disaster.
• Alternate Means of Valuation - when the primary means of valuing a security is not available (illiquid markets anyone?) then what is the secondary means of calculation value.

Some further notes from David's talk:

• AAA rating should imply a failing once every 10,000 years, with some super senior CDO tranches being rated as better than AAA - David pointed out that even as recently as the early 1990s there were problems in the US housing market that indicated that AAA did not mean what it was taken to mean.
• On structural imagination, David said that quants and risk managers must look for unrepresented variables in a model and track them early to monitor their effects
• On feedback he cited an example where increased returns drove product innovation which drove up (CDO) volumes, which caused underwriting standards to fall, that allowed further complexity, that then led to unreliable risk estimation which then led to more product innovation... and so on.
• He suggested that quants adopt the "second means of valuation" mantra in a similar way to credit specialists always having the mantra when assessing credit of "what is the second means of repayment" (e.g. a lien on a house) when the primary means (mortgage payments) goes away.
• David showed a nice classification from an IASB paper on classifying financial instruments:

Level 1: fair values measured using quoted prices in active markets for the same instrument.

Level 2: fair values measured using quoted prices in active markets for similar instruments or using other valuation techniques for which all significant inputs are based on observable market data

Level 3: fair values measured using valuation techniques for which any significant input is not based on observable market data

David additional proposed the interesting level of "Level ?" for some products, and said that obviously more attention needs to spent on Level 2 and 3 instruments under conditions of reduced (non-existant?) market liquidity.

Summary Session:

Paul and David then answered some questions from the audience:

• Paul said that some risk managers lacked the imagination necessary for good risk management, being confined in standard procedures, beliefs and ways of doing things. He wants risk managers who are good at thinking laterally.
• Paul said that risk management was often an afterthought, not part of the trading process.
• David said that VAR has proven useful despite its weaknesses, in his opinion preventing failures from non-extreme events regardless of the recent extremes
• David said that in answer to Taleb's criticism of using history in modelling, it quite frankly is all we have to go on. He quoted Mark Twain in that:

"History does not repeat itself but it does rhyme"

The talks were interesting, and even on points that have been discussed elsewhere both speakers had some interesting slants and good analogies. But maybe I am biassed, as the wine afterwards wasn't bad either!...

Best execution 2009 - July 1st 2009

A few summary points I took from the Best Execution Europe 2009 event courtesy of Incisive Media that I attended yesterday morning.

The event started with a presentation by Michael Fridrich, Legal and Policy Affairs Officer of the European Commission:

• From what Michael was saying then in my view, it seems that the EU is using the G20 declaration on financial stability in April as a remit to regulate in many areas (not all of which related to the current crisis, see last paragraph in this post)
• He said that the EU is currently working on removing national options/discretions with respect to financial markets in order to create a single EU rule book and combining this with stronger powers for supervisors including much harsher sanctions against offending institutions
• They are also reviewing the necessary information provided to investors in OTCs, even if the investors qualify as "professional investors" under Mifid.
• The EU is currently reviewing Mifid and the Market Abuse Directive (called "MAD" which is at least humorous...)
• EU is also unsurprisingly looking at the regulation of Credit Ratings Agencies (CRAs) given their involvement in rating CDOs and other structured products

So in summary it was a civil servant PR exercise with few surprises, other than we are going to regulate anything that moves. On to a panel debate on "build vs. buy" for execution management software. I will try and put my obvious vendor bias to one side in summarising this one:

• The panel summarised that this decision was about the usual issues of time to market and what is an institutions core IP
• A senior IT manager from JPMorgan said they both build and buy - but given the size of their organisation and the need to innovate they do build a lot
• The COO of Majedie Asset Management said that "build" was "20th Century" and the IT should focus now on "assembly"
• He added that if IT lead a procurement process he finds this tends to lead to more proprietary solutions than if business is managing it.
• He summarised that business people should have the mandate to define inputs/outputs to a requirement and that IT were not qualified to do this.
• Putting it more controvertially he suggested that IT people should work for IT companies
• The JPMorgan guy responded that "assembly" of external components can lead to excessive staffing in managing all the plumbing, and that build in house could build a more generic and targetted platform that would need less management
• The moderator summarised the build vs. buy decision as one of balancing time to market and how bespoke a solution is alongside of looking at the risks for buying of 1) integration risk 2) vendor risk and for building of 1) delivery risk 2) key man risk

The debate on this was pretty standard, but the guy from Majedie was at least controvertial in what he was saying, (including at one point that "investment management does not scale"). I assume he is trading simple products and as such is able to outsource more than the JPMorgan manager. My own slant is that more vendor products need to be designed to integrate easily with the IPR of a financial institution i.e. less black box.

Tom Middleton of Citi then did a presentation on (equity) market liquidity and market fragmentation:

• He started by saying the Smart Order Routing (SOR) was like "Putting Humpty-Dumpty back together again" from all the sources of liquidity now available under Mifid.
• Being no expert in SOR, I was excited (?) to learn a new term which was "finding Icebergs" - apparently an "Iceberg" is a large non-public ("dark")  order being posted with a much smaller public trade order.
• He said that market fragmentation will increase further but there will be less trading venues as the market consolidates.
• New algorithms will be developed more specifically for trading on dark pools of liquidity
• Clearing and settlement costs are still high across Europe which limits the usage of small size orders in trading but trading volumes will continue to grow
• The drive to ever-lower latency will also continue
• Usage of SOR will grow

Tom's presentation was then followed by a panel debate on Smart Order Routing:

• A manager from Baader said that the German area market of Europe was not very sophisticated yet, with most German clients specifying exactly where the trade should be executed hence nullifying the need for SOR.
• Deutsche Bank (DB) mentioned that having both US and EU operations had helped them get SOR in place for the EU quicker given their US experience.
• UBS and Baader both said that Algo trading and SOR are increasingly integrated and will merge with the Algo define what and how to trade and the SOR component determining where
• DB said that a "tipping point" towards usage of SOR in the EU will occur when more than 20% of trading occurs away from the primary exchanges.
• DB said that 60% of US liquidity was due to algorithmic trading and that there were now no EU barriers to this happening in European markets and bringing with it increased liquidity, although issues such as not having a consolidated market tape for trading made things more difficult
• Neonet said that clearing and settlement costs were still a barrier to widescale SOR adoption.
• IGNIS Asset Management said that SOR was a "high touch" service for them, requiring SOR vendors to be very responsive and client focussed. In selecting SOR vendors they were concerned with data privacy and also with having a real-time reporting facility to see how orders were being filled.

And finally (at least before I had to leave) there was a presentation by Richard Semark of UBS on Transaction Cost Analysis (TCA):

• He was surprised to find that there were not many presentations around on TCA
• TCA vendors are behind the times and are not up to date with current developments
• Historically TCA was about what had happened (about 3-4 months ago!)
• Mifid has driven fund managers and traders to talk more and TCA is a key part of this conversation
• It is hard to look bad against traditional TCA measures such as VWAP if a stock is always rising or always falling, and this can hide a lack of performance and "value add"
• Using "Dark" for non-displayed liquidity has been a publicity disaster for the electronic trading industry
• Much Smart Order Routing (SOR) is still based on static tables of trading venues that are updated on a monthly or quarterly basis
• Market share by volume of a venue is not necessarily correlated with obtaining the best prices in the market
• TCA should be based upon a dynamic benchmark that responds to the market and trades done not against a static one
• Trade performance is not linear with trade size which is an incorrect assumption in much of TCA
• Trade risk (variability in outcomes) deserves more focus
• Portfolio TCA is much more complicated where the trading of a single stock cannot be looked at in isolation of its effects on the whole portfolio
• Real-Time TCA is becoming ever more important to clients since it allows them to understand more of what is going wrong/right with filling an order
• TCA providers are not doing a good job for clients, not using the right data or answering the right questions for clients

Not sure who the TCA providers he refers to are, but maybe I should find out to see what they offer...

 

 

 

 

Over The Counter Arguments

George Soros has waded back into the current saga concerning OTC derivatives in his article last week in the FT. The main part of the article focusses on financial markets reform, but ends with a vehement attack on derivatives, building upon some of his earlier ideas (see post) and seemingly going much further:

"Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent."

He ends by saying that "CDS are instruments of destruction that ought to be outlawed.". To the extent that Mr Soros attracts press/political attention is probably something the OTC markets should worry about, although it would seem his views are already consistent with many involved in influencing the US financial markets policy - take for instance the submission by Christopher Whalen to the US Senate on OTC Derivatives:

"Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets."

Fortunately however there are also some more balanced views around - I found the following post on the "(in)efficient frontiers" blog, which references the earlier Senate submission by Richard Bookstaber on OTCs. Mr Bookstaber starts by saying that derivatives can improve financial markets, allowing investors to shape returns, exactly meet contingencies and package risk. Mr Bookstaber also puts forward a very clear summary how participants have also over recent years use derivatives to game the system to achieve tax avoidance, investment mandate avoidance, speculation and to hide risk-taking.

So back to the Soros article, there was a letter in response a few days later from a partner at the legal firm Ashurst's, saying that unfortunately risk does not confirm to a standard. In this I agree, standardising contracts can lead to increased complexity - there was a recent example given by a swaps dealer at JPMorgan who said that a corporate with particular cashflows to be hedged does want to be dealing with the basis risk and admin of using standardised contracts - the corporate treasurer wants something that matches the exposure they have and takes it away, end of story. Again this is an example of derivatives "risk" not being just about the product type, but also about which institution is holding the contract and what they are using it for (see earlier post).

Not sure however how much the Ashurst's partner who wrote the response letter is worried about lucrative legal fees for OTC derivative contracts dying off if Soros-like standardisation occurs - it is a world of vested interests at the moment, never more vested than in a crisis...

 

Risk in the Hands of the Holder?

Given the ongoing debate about "too big to fail" and whether we should head back to the days of the Glass-Steagal Act, then here is a slightly different slant on the problem of systematic risk put forward in an article by Avinash D. Persaud.

In the article, Avinash makes the very good point that increasing capital requirements across the board is not the only response that regulators should consider, and that the risk of a financial product cannot be determined in isolation of who is holding it:

"At the heart of modern regulation is the erroneous view that risk is a quantifiable property of an asset. But risk isn't singular. There are credit, liquidity, and market risks, for instance—and different parts of the financial system have different capacities to hedge each. Thus, risk has as much to do with who is holding an asset as with what that asset is. The notion—popular in the U.S. Congress—that there are "safe" instruments to be promoted and "risky" ones to be banned is deceptive."

Obviously the last point is very relevant to the OTC markets at the moment. Avinash suggests that capital requirements should be tailored to what type of organisation is holding a risk and that organisations ability to hedge it, and outlines past mistakes made by regulators:

"By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for."

On banks and credit risk, then for those interested there is a good regulatory arbitrage example for credit risk described in the following article. Fundamentally I think the paragraph above illustrates some of the reasons why it is right to worry about rushing in new regulation too quickly - certainly things need to change but when dealing with large and complex systems (i.e. in this case Financial Markets) changes should be introduced incrementally in order to understand how the system responds.

Given the political imperative to "do something" then regulators find it all too tempting to stick their noses in everywhere, even in areas that did not lead us to the current crisis - take for instance the regulatory initiatives over the past year in short selling, hedge fund regulation and more recently the dangers of "dark pools" (at least dark pools sound scary I guess?). Where will the next "bogey man" appear on the regulator's radar and what will be the unintended consequences of government pressure on regulators to keep us all "safe"?

Risk as Sales Support?

Article in FTFM yesterday saying that the risk function is being ignored by asset managers when formulating new financial products.This seems consistent with some recent comments from one risk manager who said that their role was a lot to do with sales support i.e. to convince potential investors that the asset manager has good risk management capability. Given all the discussions on the sell side about the role of risk managers and the risk function, sounds like the debate should open out more onto the buy-side too.

Data Pirates and Getting a Share of the Booty

Seems like data piracy (illegal sharing of logon IDs and scraping data) is costing the financial information industry around $8 billion in subscription revenue each year reports Inside Market Data. My first reaction is that $8 billion is a lot to loose, and shows just how (surprisingly?) big the whole market is ($23 billion apparently). My second is that I wonder how many end-users who share logins illegally would not that if they faced the full costs, so maybe the number should be a lot less? Either way the stat is interesting, particularly at a time when Bloomberg seems (!) to be taking a more constructive stance on data provision and partnering. Ironic also that the report suggests that the biggest set of guilty parties on illegal page scraping are the data vendors themselves, checking on each others data.

The company that put the survey together, Burton-Taylor, seem to have some interesting background on the major data vendors. The first is on news content, saying that Bloomberg seems to concentrate on news alerts whereas Reuters seems to put more emphasis on news analysis.  The second shows shows financial information/analysis revenue broken down by vendor and geography in 2008, showing how dominant Thomson Reuters and Bloomberg are in the US and EMEA, with Quick having significant share with the big two in Asia. The third shows revenue broken down by segment and geography with FX/Fixed Income Sales & Trading, Equity Sales & Trading, Investment Management and Corporate expenditure dominating. 

Which email have you hidden behind?

Pet subject (partly because I have been guilty of it), but good reference article by Luke Johnson of the FT on email and how many of us hide behind it rather than speak face to face to colleagues and clients.

Twittering the Wisdom of Crowds

Deserving an award for title alliteration, an article on Finextra has announced that Streambase Systems have connected their system to Twitter, the fashionable microblogging site. Regardless of the intent, it is an excellent marketing exercise by Streambase (er, maybe one that I should remember for the future!...).

Reasonable comments from Finextra at the end of the article, saying that Twitter is a notoriously bad source of information, very open to (designed for?) rumour, and as such it would be difficult to see what real information traders could extract from the noise. At one level, then rumour and counter-rumour are the basis of markets, although the recent financial crisis has illustrated how powerful rumours can be. I would suggest it begs the question as to when rumour and counter-rumour is part of the price formation process, and when it becomes market manipulation.

On a related note, the Efficient Market Hypothesis (EMH), the financial theory that all information (including rumours) is reflected in current prices, has been coming under some attack in the press recently. With a fund-management and Monty-Pythonesque slant, James Montier of Société Générale takes EMH to task in his recent article in the FT (see Pablo Triana for an alternative view).

My opinion is that EMH has still got some legs in it as a model, but behavioural finance probably has a lot more to explain (or rationalise?) about this theory and others in light of recent events. Anyone got a different opinion, or do I need to open a Twitter account to find out?...

Liquidity Risk

Our think-tank friends at JWG-IT organised a great event yesterday, with several of the top banks coming together to share their thoughts on what is currently causing them the most pain in implementing the FSA liquidity risk requirements (see FSA Consultative Paper CP08/22 for background).

A few points I took from the meeting:

• FSA is moving from a "principles" based approach to regulation to "outcomes" on to "proof of judgement" as the basis for assessing financial institutions
• What liquidity stress tests the FSA wants the financial institutions to perform is still far from clear
• The above uncertainty is not helping when combined with an implementation deadline of this October
• Whether liquidity risk must be managed at the branch or group level is a key unanswered question which has enormous implementation implications
• The data requirements are enormous and since a group-wide issue requirements greater central access to data across all departments - unlike traditional market risk which is currently more siloed within each business division
• The granularity of data required (down to transactions, detailed cashflows for complex derivatives) is very challenging
• Management of intraday liquidity requires real-time cash transaction reporting which is currently not being done/is difficult to do
• "Ownership" of liquidity risk implementation typically resides within a bank's treasury function but awareness, ownership and involvement of all departments (e.g. market risk) could be greatly  improved

A lot more interesting issues and detail on this meeting plus survey results will be available from JWG-IT soon (see their liquidity risk site)

Liquidity Derivatives - the next OTC?

Given the drive the FSA is making in forcing financial institutions to implement "Liquidity Risk Management" (see background on JWG-IT site) are we going to see renewed interest in the creation of "Liquidity Derivatives" to hedge liquidity risk? I found the following post on the subject applied to hedge funds but not much information else where, although Tony Jackson did an interesting article on liquidity in the FT last week, indicating that liquidity derivatives have been tried before with little success.

I was thinking of the advent of credit derivatives being driven in no small part by Basel II regulation on capital charges for credit risk. Maybe given the current battle going on around OTC regulation (see FT feature today) there are institutions working on liquidity derivatives but nobody in the finance industry wants to admit that they are already creating the next "innovative" OTC to nullify regulatory charges?

Mr Geithner better watch out, innovation will always beat "rules" in my view...

OTC Valuation by SGSS

Given all the recent attention that OTC derivatives have received (see Geithner letter), then a topical update on the work we have done with Societe Generale Security Services (SGSS) on OTC and structured product valuation services has been written up on Securities Industry News. The work involved extensive integration with Mysis Summit, where our TimeScape data and analytics management system is used to provide "Golden Copy" of market, reference and derived data for the derivative products being valued. The section on TimeScape says:

"The Summit FT solutions are integrated with SGSS' market data software tool TimeScape, licensed from London's Xenomorph in November 2007. This produces a "golden copy" of end-of-day prices from 15 different information suppliers. The unit also processes information related to 70 different currencies and 5,000 volatility surfaces, which give three-dimensional views of how much and fast a security can move up or down. With Summit's product, each surface can include between 200 and 500 data points."

From talking to some of the SGSS team at our recent user group, the thing they most seem to value about TimeScape is its ease of use in describing and managing any kind of product, allowing product and market data specialists to use and customise the system without the need for specialist technology knowledge. This echos some of the things that were said about TimeScape after a demo to Lab49 last year. 

Alternatives Need a Bigger Umbrella?

Interesting article in the FT today about why the US exodus from traditional exchanges might not be repeated here in Europe, which is contrary to the recent marketing mantra of the alternative trading venues such as Chi-X, Turquoise and Equiduct. If correct, the economics outlined in the article look justifiably prohibitive:

"Merely to break even, an alternative platform with a cost base of about €10m would need to do 100m trades a year. Quite a task, given that the 208-year-old London Stock Exchange, which reports full-year figures on Wednesday, said in March it was on course for about 190m in its UK orderbook."

The article points out the difficulty of starting an alternative trading venue against a dire economic background and emphasises this by ending with:

“Xavier Rolet, the LSE’s new chief executive, should be praying for rain.”

Microsoft CEP Surfaces as "Orinoco"

Seems like Microsoft have now gone public on the Microsoft TechEd site that they have a Complex Event Processing (CEP) engine that will be coming to market shortly (see MagmaSystems blog post ). One of my colleagues Mark Woodgate attended a briefing event at Microsoft for this technology back in February this year - here's an extract from some internal notes that Mark made back then:

"Microsoft CEP is very similar to StreamBase conceptually (and not unsurprisingly), in the sense that there are adapters and streams and how you merge and split them via some kind of query language is the same. However, StreamBase uses the StreamSQL which as we have seen is SQL-like in syntax but Microsoft CEP uses LINQ and .NET and although conceptually it is doing the same thing, it does not look the same. StreamBase’s argument was you can be an SQL programmer to use it and don’t need lower-level like .NET; however, it’s not SQL really as it has all these ‘extensions’ you have to learn so using .NET might look more tricky but in fact it makes sense. They don’t have a sexy GUI yet for designing CEP applications like StreamBase but it will be done in Visual Studio 2008.

 

Currently, you build various assemblies (I/O adapters, queries and functions) and then bolt them all together, called ‘binding’ by command line tool. You then deploy the application onto one or more machines using another tool so it’s a manual process right now. They are aware this needs to be made easier and more visual. They are allowing other libraries to be bolted in via the various SDKs so it’s pretty open and flexible. It works well with HPC and clusters/grids (or so they say) and of course can be used with SQL Server. The CEP engine also has a web interface based on SOAP so at least non-Windows based systems can talk to it"

 

The release of this technology will be an interesting addition to the CEP market and to the Microsoft technology stack in general. Assuming performance is at credible levels (i.e. not necessarily leading but not appalling either) it will certainly bring both technical and commercial pressure to bare on existing CEP vendors (see earlier post on Aleri/Coral8) and has the potential to broaden the usage of CEP. Obviously Linux-Lovers (sorry, I didn't mean to be personal...) will not agree with this, but Microsoft is putting together an interesting stack of technology when you see this CEP engine, Microsoft HPC and Microsoft Velocity coming together under .NET.

 

Regulating OTCs Out Using Capital?

Following on from the warnings on over-regulation in my post last week on the OTC markets in London, Larry Tabb of the analyst firm the Tabb Group is pointing towards increased capital requirements as the stick the regulators will use to move the finance industry away from the perceived dangers of the OTC markets (see article here).

Data Quality and the Future of Risk

A new survey from the Economist Intelligence Unit (sponsored by SAS) of over 300 financial institutions world-side has put data quality and availability as a key issue to be resolved if risk management is to be fit for purpose following the financial crisis:

"Culture, expertise and data are weak points in current risk management"

A summary of the survey report is available here.

Analytics Management from Celent

A new report from the analyst firm Celent advocating enterprise transparency and consistency in the pricing of OTC derivatives and structured products - great that an analyst firm is acknowledging the need for analytics management as a complimentary discipline to the more established principles of data management.

Technical and Human Analysis

The FT Alphaville Blog put up a post earlier this week about Bloomberg being critical (see article) of technical analysis and its ability to make money using techniques such as "Bollinger Bands". In summary Bloomberg have backtested some of the most common technical analysis strategies over recent years and found the majority of them have lost money.

This took me back a few years to a conversation with a derivatives trader in Hong Kong who having come from a mathematical background was a natural believer in "efficient markets" in that all information known about an asset was reflected in its current market price (and hence that drawing some lines on a chart would not tell you anything that the market had not already factored into the price of the asset).

On one occaision, the trader was phoned by a broker who asked him if he had "seen that the Hang Seng had just broken its resistance point". Initially having dismissed the broker's call as rubbish, then upon reflection he knew the broker was going to be calling many of the major players in the market and that many would listen to the broker and act upon it. Thinking about it further, the trader decided to go along with the broker's trading idea simply because others would and it would become a self-fulfilling opportunity. Sure enough, the Hang Seng did rise that day as the broker had predicted and the trader made some (reasonable) money from the trade.

So whilst technical analysis has its failings, human behaviour ("herd instinct" or the ubiquitous "Mr Market") cannot be ignored. Given the underlying human causes to the current crisis, the more work that can be done on better modelling of human behaviour is all to the good in my view.

Less risk on the buy-side?

Interesting but counter-intuitive survey results discussed on the Advanced Trading blog, suggesting that risk function has lost status at buy-side institutions.

Fight-back by the OTC Market?

An FT article I read earlier this week put me on to an interesting report on the OTC derivatives market commissioned by the City of London and written by a consultancy Bourse Consult. The report seems to be have been commissioned in defence of OTC industry against the predictable knee-jerk of regulatory proposals following the current financial crisis. Main points from the report are:

• The OTC market is global and very large, much larger (by notional I guess) than either the exchange traded market or the cash markets
• London accounts for 43% of the OTC market, with 24% in the US
• It clarifies and emphasises that CDOs on ABS sold into off balance sheet special investment vehicles are where the main losses in the current crisis have been incurred
• The CDS market and the OTC market in general did not cause the current crisis
• Being seen to be "doing something" is driving much stricter regulation for CDSs and the whole of the OTC market, not just for the CDO products at the heart of the crisis 
• Those arguing that OTCs must be traded on exchanges are mistaken since the OTC market and the exchanges are complimentary and need each other to thrive and develop new products
• Many OTCs could by cleared centrally by a CCP without requiring listing on an exchange
• However desirable, there are certain types of OTCs that are not suitable for a CCP
• The current crisis was caused by mistakes by the ratings agencies, poor risk management by the banks and a lack of questioning of these participants by the regulators
• Fundamentally this is a people-led not product-led crisis
• Pressues to set up regional CCPs are mis-guided as the OTC market is a globally one and ultimately it will decide which CCPs succeed.

The report is well written and well worth a read. However, to suggest that the current financial crisis is purely people-led and that financial products are blameless is not completely the case in my view. I guess it depends upon your interpretation of whether regulation should directly limit the types of financial products created and their usage, or simply focus on regulating the people who are creating and using them. Given the current focus on getting CCPs set up for CDSs and other OTCs, it seems like governments and regulators are taking the approach of directly addressing perceived issues with financial products in addition to the more obvious (but more difficult?) people issues.

Also sounds like there is some work to be done in the EU, US and elsewhere if London is to remain the global centre of the OTC market - given the current performance of the UK Government this is not an encouraging prospect for London.

High Performance Spreadsheets

Another article about the operational risk generated by the usage of spreadsheets within the financial markets (see earlier posts), appeared in the April issue of Waters Magazine.
 
The articles highlights how spreadsheets are largely used within financial institutions and suggests that the current regulation requirements for more transparency and ad-hoc risk management might push the proliferation of spreadsheets even further. The articles also refers to the progress and improvements made by Microsoft in recent versions of Excel to increase the security of spreadsheets.
 
Xenomorph has worked closely with Microsoft on hosting its time series database within SQL Server 2008. The case study we have written together describes how SQL Server 2008 offers integration within Office Excel 2007 so that whilst the spreadsheet is still the end-user viewing tool, operational risk is reduced by engaging Excel 2007 as an analytics and reporting tool and not as a mean of storing data.
 
Our TimeScape solution offers more than 700 easy to use add-in functions to Office Excel 2007 and we are currently working on the use of Excel Services, part of Microsoft Office Share Point Server 2007, to further enhance the centralized approach to spreadsheet.
 
If you are interested in how Xenomorph solves the problem of spreadsheet management, then take a look at our (newly updated) website. Here we explain how to solve the problem and how Xenomorph Spreadsheet Inside technology can bring unstructured spreadsheet data and complex calculation within a centralized data management system, increasing transparency and reducing operational risk.

Capital requirements for Asset Managers

Article in the FT today saying that the Financial Services Authority (FSA) has criticised asset managers for poor risk management, and that these failures might force it to impose higher capital requirements on some institutions.

The Investment Management Association (IMA) countered by saying that the FSA guidelines on capital requirements for asset managers were unclear, but also added that as asset managers did not hold client-owned assets on their balance sheets they did not need to hold capital against these assets unlike the banks.

I understand this last point by the IMA, but surely given an institutions fees (aka revenues) derive mainly from fees for managing these assets, surely the IMA is not doing itself any favours by effectively suggesting that the (currently volatile) value of these assets are not relevant from a institutional risk point of view? Poor investment performance leads to redemptions, leads to reduced fees, leads to concerns over institutional stability, leads to more redemptions etc, etc.

Anyway, interesting that this is receiving some regulatory attention and maybe buy-side risk management will soon be moving beyond helping to market and sell the latest investment product...

Merging in public is difficult...

Sounds like Aleri and Coral8 in the CEP (Complex Event Processing) market are not doing the best job they could of managing the publicity surrounding their recent merger, not helped by announcement of a CEP capability by Sybase, based on Coral8 source code. 

Explained more in a post on the Magmasystems Blog, and made more entertaining by the aggressive marketing tactics of Streambase in responding to the merger by offering a software trade-in facility for clients of Aleri and Coral8 (see press release).

UK invests in a CDO cubed?

Entertaining post by Paul Wilmott on his blog, comparing the UK Government's latest round of financial support for RBS to mezzanine tranche in a CDO. Bet HM Treasury didn't think it was going to invest taxpayers' money in such innovative products...

Regulatory Camouflage

My faith in government institutions and the people working for them has been restored by Martin Wolf of the FT when he pointed out an excellent paper "Why Banks Failed the Stress Test" by Andrew Haldane of the Bank of England. Reading this is a complete contrast to my experience at the FSA presentation on stress and scenario testing the other week (see earlier post).

The paper ends by putting forward five proposals for improving risk management:

• Better Scenario Definition - Regulators defining multi-factor scenarios for the industry that are truly representative of extreme tail events.
• Regular Scenario Evaluation - A common set of scenarios evaluated and reported upon to the regulators on a regular basis.
• Second-Round Stress - Making sure that the consequencies of stress testing for individual institutions can be evaluated for system-wide risk.
• Active Management of Risk - Ensuring that management take and can explain actions that provision for the risks identified, and do not simply passively report on risk levels.
• Transparency - Access to institutional stress testing results by regulators and potentially by the market as a whole through annual report and accounts.

In addition to solid content, Andrew Haldane writes a good story, and I love the usage of "regulatory camouflage" in the serious point below:

"...is that stress-testing was not being meaningfully used to manage risk. Rather, it was being used to manage regulation. Stress-testing was not so much regulatory arbitrage as regulatory camouflage."

A lottery of bonuses

Another application in an FT article of the long-dated option strategy (see earlier post) this time to discredit the UK Government's attempts to limit the risk of the short-term bonus culture in financial markets. The article is funny and makes a lot of sense, but the need to "do something" for the outraged public will unfortunately mean that not many politicians will take any note of it.