Risk Proposal from Roubini

Article in the FT today by Lasse Pedersen and Nouriel Roubini (somewhat accurate predictor of some of our current problems) on regulatory captical and prevention of another crisis. Pedersen and Roubini say that current regulation focuses too much on individual bank risk and does not consider the systematic risk that could be caused by the failure of an individual bank. They propose the introduction of a new systemic capital requirement and systemic insurance programme, although in this article do not present too much detail on the mechanics of the "systemic risk" calculation. More detail can be found at their NYU Stern project on restoring financial stability.

CDS Asymmetry not for Soros

Interesting views in an article by George Soros in today's FT. Whilst dealing with the current crisis and the difficulty of its remedy in general, Soros spends a little time on short selling and continuing his warnings about CDS contracts and other OTC derivatives.

In contrast with short selling, where upside is limited but downside risk is not (and increases as more losses are incurred), he explains that effectively shorting a stock through buying a CDS contract has the reversed asymmetry of risk. On buying a CDS, the downside risk is limited (to the premium), whilst the upside risk is unlimited (not sure I agree, maybe practically unlimited is better used). Using this asymmetry in risk profile, he joins John Dizard in railing against what he perceives as the instability caused by the CDS market and "toxic" OTC derivatives.

He suggests that shorting is an acceptable market practice (I guess he would, have made a lot of money from shorting) but that some market constraints might be sensible in re-introducing rules such as no naked short-selling and allowing shorting only on an up-tick.

Most controversially rather than just accepting the common view that CDS contracts need to be traded and cleared within regulated markets, he advocates a more stringent process where OTC derivatives would need to go through a very formal and regulated "issuance" process similar to that undertaken when issuing a new stock on an exchange. Given history and the market's economic need for innovation I struggle to see this happening on a large scale, even in light of the crisis - but I guess nothing is to be ruled out in current times.

EDM Council on the Meaning of Data

The EDM Council has today released its first draft of a Semantics Repository for review by the industry. Its intent is to establish a common meaning for terms used in financial markets and data management in particular. How it is meant to be used and how it fits with other standards such as FpML and MDDL is briefly outlined by the following article. 

As already mentioned in our earlier post, it would be great for the industry if this time of crisis provides the need and motivation to get standards in place. I guess we are all fighting against the profound Tannebaum quote of "the nice thing about standards is that there are so many of them to choose from".

I wish the EDM Council every success with this effort, although the irony that we vendors and users of centralised data management systems and proponents of the single "Golden Copy", need to do better ourselves on establishing centralised industry standards for data. As I say to my five year old son "do as I say, not as I do"...

CEP in 2009

Interesting predictions for complex event processing (CEP) in 2009 (click here for link) - sounds like some form of reality is appearing in this area of the market, accelerated by the current financial crisis. Entry of bigger players and usage of LINQ in CEP will be interesting too.

Underrated, Overrated

More flak for the ratings agencies in the FT today with the article "Warning: rating agencies can do you harm", suggesting that agencies have moved from under-assessing risk (and causing financial damage in the process) to now cautiously over-assessing risk (and causing financial damage in the process).

The recent downgrading of Greece, Spain, Portugal (and potentially Ireland) won't gain them any political friends in the EU review of their role in the markets - all recent news seems to lead to "tails you lose, heads you lose" for these institutions and points to further trouble ahead...

Challenging Fair Value

Concise letter on the continuing debate on fair value accouting to the FT from Hugh Shields, Chief Economics Advisor to the Institute of Chartered Accountants of Scotland.

It seems that most commentators come down positively on the side of fair value accounting from what I have read, with the two main points of:

• Don't blame the messenger
• Pro-cyclical behaviour is driven by the regulatory calculation based on fair value accounting, not by fair value accounting in itself

A recent paper "The Fair Value Controversy: Ignoring the Real Issue" and survey "Reactions to an EDHEC Study on the Fair Value Controversy" by EDHEC seem to support this view, with only 25% of respondents believing that any amendments are necessary, and 75% believing that changes will only lead to more problems.

Unfortunately, it would seem that the SEC in the US has produced 250 pages of suggested tweaks to fair value accounting (see Lex article). Maybe the desire for preventative rules and the political need to be seen to be "doing something" are too strong for regulators to resist...

Happy Birthday Spreadsheet!

Article on PCMag saying that the spreadsheet is 30 years old. Whilst wishing it a happy birthday, the author, John C. Dvorak, has a good rant about how spreadsheets have been the major weapon in the rise to power of the accountant in business.

Good job he did not spend too much time looking at their usage in financial markets or else his rant would have been much longer, given past issues with spreadsheets in financial markets. The spreadsheet (which means Excel at the moment) is a great tool that is:

• a calculator;
• a report writer;
• a database

In my view it is the latter usage of desktop spreadsheets to store data where the problems mainly reside, not its usage as an analysis tool. Faced with inflexible trading and risk management systems that do not allow instrument and trade data to be represented quickly or correctly, it is unsurprising that traders, portfolio managers and risk managers resort to spreadsheets as the "pressure relief valve" for their business activities.

Delivering systems that can support both complex and non-standard instruments and trades in a transparent manner should be a focus in a world where that the lack of transparency over credit derivative pricing has been such an issue. The inappropriate usage of spreadsheets is a very small part of the current problems we are experiencing in the markets, but addressing this would be a positive step in creating a data management foundation that encompasses all data used by a financial institution, not just that data that is easy for software vendors to represent in their systems.

Anyway, enough of my spreadsheet hobby-horse, for some light relief and to celebrate 30 years of summing rows and columns, take a look at the Eusprig web site for a list of the most notable spreadsheet failures.

Financial Modeler's Manifesto...

Echoing all of the recent focus on model risk at the RiskMinds event before Christmas (see earlier post), Emanuel Derman and Paul Wilmott have put together "The Financial Modeler's Manifesto" as their serious but amusing guide to how financial modeler's must conduct themselves in future.

I particularly like the self-effacing summary oath for financial model-makers everywhere:

The Modelers' Hippocratic Oath

~ I will remember that I didn't make the world, and it doesn't satisfy my equations. 

~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

~ I will never sacrifice reality for elegance without explaining why I have done so.

~ Nor will I give the people who use my model false comfort about its accuracy.
Instead, I will make explicit its assumptions and oversights.

~ I understand that my work may have enormous effects on society and the economy,
many of them beyond my comprehension.

 

Libor no more...

Following the ongoing story of Libor diverging from the OIS rate (see earlier post), Risk magazine reports that Libor risks losing its place as a funding benchmark. Spreads against the OIS have tightened recently (see recent article in the FT), but Mustafa Chowdhury, head of US interest rate research at Deutsche Bank in New York, says that Libor is becoming less relevant as a benchmark due to banks accessing other sources of funding such as Federal Reserve Funds.

Time to change all of those benchmark yield curves across the entire institution and understand all of the pricing differences? Ouch! Maybe wait a while yet...

Originative sin

Very balanced article in the FT by John Plender on innovation in financial markets, quoting Merton Miller as saying in 1986 that "the major impules to successful financial innovations have come from regulations and taxes". Apart from a good narrative on the current crisis, Plender ends by suggesting that as both taxes and regulation are likely to increase in the near future, it may be unwise to call the death of financial innovation just yet.

Exceeding Expectations in 2009...

I currently find it a little disingenuous to blandly wish everyone a “happy and prosperous new year” given the bad economic/business/employment news of recent months – and so given the generally gloomy economic forecasts coming from the press for the year to come, maybe it is better settle upon something that should be readily achievable for all of us with please accept my very best wishes for a 2009 that exceeds your expectations.