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.