PRMIA on Systemic Risk Part #1

I attend a PRMIA seminar this morning at the offices of Ernst & Young with the rather long title of "Risk, Regulation and Financial Technology & Identifying the Next Crisis".

First up was Matthew Richardson of NYU Stern with a presentation entitled "Identifying the Next Crisis". The focus of his presentation was on systemic risk, which he defined as the risk that financial institutions lose the ability to intermediate (i.e. continue to provide services) due to an aggregate capital shortfall. He presented a precise definition of the systemic risk of a firm as:

        Expected real social costs in a crisis per dollar of capital shortage
    x  Expected capital shortfall of the firm in a crisis

Matthew explained that there are three approaches to estimating systemic risk contribution:

1. Statistical approach based on public data
2. Stress tests
3. Market approach based on insurance against capital losses in a crisis

He explained that the methods his team have used have had some statistical success against data from the past crisis in showing those organisations in crisis early. I found his presentation reasonably dry (more regression analysis etc) but I thought the following where worth a mention:

• Crisis Insurance - Approach 3 on getting firms to insure themselves against capital shortfalls in a crisis sounded interesting but ended up with the insurer being the regulator (not enough capital to insure privately) and the beneficiary being the regulator. So effectively this was a tax on the systemically significant institutions, where the involvement of the private insurers was mainly to do with price discovery (i.e. setting the right level of premium (i.e. tax) for each institution)
• Short-term Indicators - Many of the approaches we have currently (VaR etc) are short term indicators and so in good times do not inhibit market behaviour as would be desired by the regulators. A good illustration was given of how short term volatility was very much lower than long term prior to the crisis and how these merged to similar levels once the crisis hit.
• Regulatory Loopholes - He put forward that this crisis was as a result not of monetary policy but of large complex financial institutions exploiting loopholes in regulation. The AIG Quarterly Filings of Feb 2008 showed that $379Billion of the $527Billion of CDS were with clients that were explicitly seeking regulatory capital relief (i.e. get the CDS in place and your capital requirement dropped to zero). He also explained how Fannie Mae and Freddie Mac were used by banks to simply "rubber stamp" mortgage pools and magically reduce the capital required down from 4% to 1.6%.
• Where to look - He said that "like water flows downhill, capital flows to its most levered point". He said to look for which parts of the financial sector are treated different under Dodd-Frank, Basel III etc and that the key candidates were 1) shadow banking and 2) government guarantees. Also you should look for those asset classes that get preferred risk weights for a given level of risk.

As often seems to be the case, I found the side comments more interesting than the main body of the presentation, but Matthew's presentation showed that a lot of work is being done on systemic risk identification and measurement in academia.

 

 

A glass of red and contrary ideas on Triple-A risk

I enjoyed myself at the drinks reception after the NYU-Poly event. Nothing new in that I guess for those of you that know me well and like me find it difficult to resist a glass or two of red wine. Whilst attempting to circulate (I am almost 2 metres tall, so rather than "circulate" I think a more appropriate word might unfortunately be "intimidate"), I struck up a conversation with an interesting gentleman by the name of Per Kurowski.

Per is a former director of the World Bank and has some contrary and interesting ideas on the financial crisis and our current methods of regulation. His first that financial crises rarely start with assets that are perceived as "risky", which I think is a pretty self-evident point but not one that I had not previously registered. His second line of argument is that our current regulation biasses our banks away from "riskier" assets and hence away from just the kinds of organisations that are a) needed for employment creation and b) do not cause crises.

Per argues that many of the big institutions are near triple-A rated and hence benefit from being able to leverage up cheaply (at low-interest rates, since they are triple-A) and are then biased by lower capital requirements to use this leveraged funding to invest in yet more triple-A assets (SPVs/other institutions such as themselves). Hence you get the double-whammy of cheap funding and biased capital requirements which naturally leads to potential distortions in anything perceived as triple-A, and a bias away from riskier assets and the risk-takers that the world economy needs.

Per expands upon these arguments in his blog and on YouTube.

Removing the punchbowl at NYU-Poly

A few of choice quotes from the rest of the day at NYU-Poly:

• "The difference between economists and meteorologists is that meteorologists can at least agree on what happended yesterday"
• "A bubble can only be identified from a trend when the bubble bursts"
• "Capital flows from strange places to strange destinations in today's financial markets"
• "In a Basel III world, the stock price of Morgan Stanley would rise if its investment banking division were sold off"
• "Basel III is a good attempt at managing systemic risk"
• "Hedge Funds are the risk takers of the future"
• "Hedge Funds have the partnership mentality that the commercial banks have lost and should regain"
• "CCPs should not compete on risk management"
• "Economists are trained to predict everything except the future"
• "Dodd Frank was a missed opportunity to consolidate the many regulators in the United States"
• "Washing D.C. is all about turf and theatre"
• "Insolvency and liquidity risk are not clearly separable"
• "Beware the Golden Rule. He who makes the Gold makes the Rule"
• "Systemic risk is not the sum of individual institutional risk"
• "As Chuck Prince said "As long as the music is playing, you’ve got to get up and dance""
• "Systemic risk management only works when we all stop dancing"
• "Regulation should remove the punchbowl just when the party is getting started"

Regulation - Putting out the fire once you know where the fire is - NYU-Poly

The first panel session at NYU-Poly after Nassim Taleb concerned itself with the increasing competition between banks and insurers, which I didn't think reached any great conclusions as to where things are heading but did give background for why banks and insurers are increasingly offering the same services (disintermediation, regulation and industry structural changes being the main reasons). One of the presenters also said that acturial methods may provide a useful framework for unhedgeable risks taken by banks. I must acknowledge that my attention span was also challenged during this session by a very early start (up pre-6am) and a distinct lack of caffeine (later rectified many times over).

Second panel session up was entitled "The Future of Financial Regulation" and proved a lot more interesting to me given that I think I learned a few new things. Main presenter was Allen Ferell from Harvard Law School. Main point I took away from this presentation was that regulation should focus more on the resolution of financial distress after (ex-post) it has occurred at an institution rather than rules and regulations to prevent it before it happens.

I found this argument quite appealing since to a large degree it avoids provisioning for the "unknown unknowns" through more and more rules and increases in capital. The reduction in pre (ex-ante) rules would also reduce the gaming of the rules that enevitability would occur, and shareholders knowing that they would be penalised and penalised quickly following financial distress would encourage them to become more interested in the levels of risk being taken on their behalf. I guess one of the main issues for the above is how such a level of financial distress would be defined and enforced in order to act as a trigger for say automatic conversion of debt to equity. Anyway, on with what Allen Ferrell had to say:

Allen said that if a financial institution had had the foresight to see the financial crisis coming, then looking across the industry there would have been a great variation in the amount of capital needed to survive the crisis. I guess here the implication here was that higher levels of capital across the industry will help, but they are unlikely to be enough for some organisations in the crisis to come.

After the crisis had hit, he said that financing from the repo market dried up as repo haircuts exploded, and he said that this was like the modern day equivalent of a bank run (where a solvent bank faced difficulty due to having to sell good assets cheaply to satisfy demands for returning of cash deposits).

Allen said that leverage and "debt overhang" made it much less likely that a financial institution would get in more equity capital following the crisis since it implied a transfer of wealth from the stockholders to bondholders. More of this important point later.

He put forward that it was not yet clear whether the 2007-8 crisis was mainly due to insolvency or due to a bank run. He argued that it was some combination of both, and referred back to the recent re-assessment of the Great Depression being caused not by a run on (solvent) banks but rather by flight of retail investors away from insolvent banks.

He concluded that much of the action for any future crisis will have to take place after any new crisis hits (ex-post), partly due to his assessment of the disconnect between equity capital needed (the current focus of things like Basel III) prior to a crisis and an institution's financial health following a crisis.

Allen suggested that contingent capital, i.e. debt capital that automatically converted in equity based on some market trigger might be very helpful in dealing with a financial crisis. Such a conversion would happen early than if an institution agreed to it earlier and would automatically dilute existing stockholders. Overall this was a thought provoking talk and the panel discussion afterwards was interesting too. One of the panelists commented that he looked for a high leverage and high ratios of CEO to CRO compensation as his measure of where to look for the next set of risky institutions. The panel also seemed to agree that with the benefit of hindsight, allowing Lehmans to fail and the resultant drying up of the money markets was a mistake, and more consistency was needed in bankruptcy and distress resolution.

Taleb and Model Fragility - NYU-Poly

I went along to spend a day in Brooklyn yesterday at NYU-Poly, now the engineering school of NYU containing the Department of Finance and Risk Engineering. The event was called the "The Post Crisis World of Finance" was sponsored by Capco.

First up was Nassim Taleb (he of Black Swan fame). His presentation was entitled "A Simple Heuristic to Assess Tail Exposure and Model Error". First time I had seen Nassim talk and like many of us he was an interesting mix of seeming nervousness and confidence whilst presenting. He started by saying that given the success and apparent accessibility to the public of his Black Swan book, he had a deficit to make up in unreadability in this presentation and his future books.

Nassim recommenced his on-going battle with proponents of Value at Risk (see earlier posts on VaR) and economists in general. He said that economics continues to be marred by the lack of any stochastic component within the models that most economists use and develop. He restated his view that economists change the world to fit their choice of model, rather than the other way round. He mentioned "The Bed of Procrustes" from Greek mythology in which a man who made his visitors fit his bed to perfection by either stretching them or cutting their limbs (good analogy but also good plug for his latest book too I guess)

He categorized the most common errors in economic models as follows:

1. Linear risks/errors - these were rare but show themselves early in testing
2. Missing variables - rare and usually gave rise to small effects (as an aside he mentioned that good models should not have too many variables)
3. Missing 2nd order effects - very common, harder to detect and potentially very harmful

He gave a few real-life examples of 3 above such as a 10% increase in traffic on the roads could result in doubling journey times whilst a 10% reduction would deliver very little benefit. He targeted Heathrow airport in London, saying that landing there was an exercise in understanding a convex function in which you never arrive 2 hours early, but arriving 2 hours later than scheduled was relatively common.

He described the effects of convexity firstly in "English" (his words):

"Don't try to cross a river that is on average 4ft deep"

and secondly in "French" (again his words - maybe a dig at Anglo-Saxon mathematical comprehension or in praise of French mathematics/mathematicians? Probably both?):

"A convex function of an average is not the average of a convex function"

Nassim then progressed to show the fragility of VaR models and their sensitivity to estimates of volatility. He showed that a 10% estimate error in volatility could produce a massive error in VaR level calculated. His arguments here on model fragility reflected a lot of what he had proposed a while back on the conversion of debt to equity in order to reduce the fragility of the world's economy (see post).

His heuristic measure mentioned in the title was then described which is to peturb some input variable such as volatility by say 15%, 20% and 25%. If the 20% result is much worse than the average of the 15 and 25 ones then you have a fragile system and should be very wary of the results and conclusions you draw from your model. He acknowledged that this was only a heuristic but said that with complex systems/models a simple heuristic like this was both pragmatic and insightful. Overall he gave a very entertaining talk with something of practical value at the end.

IKEA and Market Risk Management – Choice is a worrying thing!

Risk management and data control remain at the top of the agenda at many financial institutions. Many have said that the recent crisis highlighted the need for more consistent, transparent, high quality data management, which I totally agree with (but working for Xenomorph, I would I guess!). Although the crisis started in 2007, it would seem that many organizations still do not have the data management infrastructure in place to achieve better risk management.

I moved apartment last week and had to face the terrifying prospect of visiting IKEA to buy some new furniture. On walking through the endless corridors of furniture ideas I wondered whether the people at major financial institutions feel as I did: I knew I needed two wardrobes, I knew the dimensions of the rooms, I knew how many drawers I wanted. Then I got to the wardrobes showroom, sat in front of the “Create your own wardrobe” IKEA software and the nightmare started. How many solutions are there to solve your problems? And how many solutions, once you get to know of their existence, make you aware of a problem you didn’t know you had? That’s how I spent 2 days at IKEA choosing my furniture and still I wonder whether in the end I got the right solution for my needs.

Coming back to risk management, I imagine the same dilemma may be faced by financial institutions looking to implement a data management solution. How many software providers are out there? What data model do they use? Are they flexible enough to satisfy evolving requirements? How can we achieve an integrated data management approach? Will they support all kind of asset classes, even the most complex? 

In these times of new regulations where time goes fast and budget is tight, selection processes have become more scrupulous. 

As often happens in life, when we need a plumber for example, or a new dentist, we look for positive recommendations, people willing to endorse the efficiency and reliability of the service. So, with this in mind, please take a look at the case study we put together with Rabobank International, who have been using our TimeScape analytics and data management system at their risk department since 2002 for consolidated data management. More client stories are also available on our website here: www.xenomorph.com/casestudies. 

I hope that many of you will benefit from reading the case study and for any questions (on IKEA wardrobes too!), please get in touch...

 

More formal management of instrument valuation needed

Xenomorph has today released its white paper “Instrument Valuation Management: management of derivative and fixed income valuations in a multi-asset, multi-model, multi-datasource and multi-timeframe environment”.

The white paper expands on the “Rates, Curves and Surfaces – Golden Copy Management of Complex Datasets” white paper Xenomorph published recently (see earlier post) and describes how, despite the increasing importance of instrument valuation to investment, trading and risk management decisions, valuation management is not yet formally and fully addressed within data management strategies and remains a big concern for financial institutions.

Too often, says Xenomorph, valuations (and the analytics used to process input and calculate output data) fall between traditional data management providers and pricing model vendors. This leads to the over–use of tactical desktop spreadsheets where data “escapes” the control of the data management system, leading to an increased operational risk.

Whilst instrument valuation is certainly not the primary cause of the recent financial crisis, the lack of high quality, transparent valuations of many complex securities resulted in market uncertainty and in the failure of many risk models fed by untrustworthy valuations.

“A deeper understanding of financial products reduces operational risk and promotes quality, consistency and auditability, ensuring regulatory compliance”, says Brian Sentance, CEO Xenomorph. “Clients’ requirements have evolved and portfolio managers, traders and risk managers recognize that it is no longer sufficient to treat valuation as an external, black-box process offered by pricing service providers”, he adds.

Nowadays, regulators, auditors, clients and investors demand even more drill-down to the underlying details of an instrument’s valuation. It is therefore important to implement an integrated, consistent analytics and data management strategy which cuts across different departments and glues together reference and market data, pricing and analytics models, for transparent, high quality, independent valuation management.

“Our TimeScape solution provides a valuation environment which offers rapid and timely support for even the most complex instruments, allowing our clients to check easily the external valuation numbers, based on their choice of model and data providers”, says Sentance. “Otherwise, what is the point of good data management if the valuations and the analytics used are not based on the same data management infrastructure principles?”

For those who are interested, the white paper is available here.

 

Investment risk not rewarded

Interesting article from the FT, Reward for risk seems to be a chimera, effectively saying that more risky (volatile) equities do not necessarily provide higher returns than less risky equities. I like the suggestion that the reason for this is that "hope springs eternal" and investors buy more volatile stocks (pushing up price) in the hope of higher returns. However, as yet another illustration of the law of unintended consequences, the article goes on to suggest that choosing a benchmark index to outperform and limitations on borrowing imposed by investment mandates may both be driving this effect, are interesting and challenging ideas for investment managers.

 

Rates, curves and derived data management remains a neglected area following the crisis

Xenomorph has released its white paper 'Rates, Curves and Surfaces – Golden Copy Management of Complex Datasets'. The white paper describes how, despite the increasing interest in risk management and tighter regulations following the crisis, the management of complex datasets – such as prices, rates, curves and surfaces - remains an underrated issue in the industry. One that can undermine the effectiveness of an enterprise-wide data management strategy.

In the wake of the crisis, siloed data management, poor data quality, lack of audit trail and transparency have become some of the most talked about topics in financial markets. People have started looking at new approaches to tackle the data quality issue that found many companies unprepared after Lehman Brothers' collapse. Regulators – both nationally and internationally – strive hard to dictate parameters and guidelines.

In light of this, there seems to be a general consensus on the need for financial institutions to implement data management projects that are able to integrate both market and reference data. However, whilst having a good data management strategy in place is vital, the industry also needs to recognize the importance of model and derived data management.

Rates, curves and derived data management is too often a neglected function within financial institutions. What is the point of having an excellent data management infrastructure for reference and market data if ultimately instrument valuations and risk reports are run off spreadsheets using ad-hoc sources of data?

In this evolving environment, financial institutions are becoming aware of the implications of a poor risk management strategy but are still finding it difficult to overcome the political resistance across departments to implementing centralised standard datasets for valuations and risk.

The principles of data quality, consistency and auditability found in traditional data management functions need to be applied to the management of model and derived data too. If financial institutions do not address this issue, how will they be able to deal with the ever-increasing requests from regulators, auditors and clients to explain how a value or risk report was arrived at?

For those who are interested, the white paper is available here.

2010 Risk in Review NY

I went along to a a Prmia event last night "2010 - Risk Year in Review". The event started with a somewhat overwhelming brain dump of economic and credit statistics from John Lonski, Chief Capital Markets Economist at Moody's Analytics. In summary he seems very bullish about corporate credit spreads tightening given the way in which corporate profit growth is surging ahead of debt growth. His main concern for the economy was maybe unsurprisingly the US housing market and whether this will bottom out and start to rise in 2011. Given fiscal imbalances and competition from emerging markets he did not think that inflation was a big risk despite activity such as QE2.

Robert Iommazzo of search firm Seba International did a fairly dry presentation on industry compensation for risk managers. Seba seem to getting around having had a big presence at Riskminds in Geneva last week. This section only livened up when the questions started after the presentation, and is probably worth noting that the UK FSA is being perceived as a "Big Brother" with its involvement in setting compensation policies in financial markets. Obviously the FSA is not heading back to the heady days of the 1970's where central government set industry pay rises (journalists please note this meant you back then!), but it is also obvious that such control over an individual's remuneration is something that goes totally contrary to an American way of thinking. UK Government needs to be mindful of this perception particularly if it leaves itself open to arbitrage on compensation policy from other financial centres.

Panel debate followed, involving Ashish Das of Moody's, Yury Dubrovsky of Lazard Asset Management, Jan H. Voigts of the NY Fed and Christopher Whalen of Institutional Risk Analytics. Main points:

• Chris said that he was one who was predicting a further fall in the housing market next year, and he asked the audience that when they looked at economic statistics, credit spreads,the Vix, bond spreads, did anyone getting the feeling the things are "normal" yet? Using these numbers and plugging them into a model does any believe the results are stable and can be relied upon? The audience fundamentally seemed to agree with these "warning" questions.
• Jan asked the audience to consider how believable is your data and to try to understand what data is critical for your business and that is imperative to create tools to manage this data appropriately. Jan said that the biggest challenge for financial institutions going forward is how to calibrate what rate/volume/type of business you can transact safely and that this needed a lot more consideration.  
• Yury said that he finds that the risks present in 2008 are still around in 2010, but now with the addition of European sovereign credit problems and the raft of regulation heading towards the industry. To add to this pessimistic note, he also said that some of the interest in "hot" emerging markets such as the BRICs was resulting in investments in lower quality IPOs relative to previous years.
• Ashish thought that systemic risk was going to become more important for the industry. With the setting up of the Office of Financial Research (OFR) next year, he suggested that the industry needed to take much more of a lead in sorting out its own house in advance of letting the regulators do so. On the subject of models, he said that models should supplement human judgement but not replace it, and mentioned the quote by George E. P. Box that "all models are wrong, but some are useful".
• Chris suggested that the role of risk managers will become more like that of a credit collector, with more involvement in actually seeing what can be recovered once a default has occurred. He also suggested that the industry should create its own consensus-based ratings (supplemented by the existing CRAs) to get a more reliable view of credit.
• Ashish echoed some of the speakers last week at Riskminds in saying that regulatory compliance is not risk management, and that practitioners should do more to guide the regulators.
• On the subject of risk culture, Yury asked how many risk managers knew data, quant, markets and how to deal with the egos of traders and senior management. This last point seemed to be conceded by the audience as a major weakness of the risk management profession and goes back to whether a risk manager is willing to put his career on the line to go against accepted business strategy.
• Chris added that having worked at several investment banks he had not yet experienced a risk manager attending a senior committee, let alone a risk manager speaking up against a senior trader. He talked of two business models "Paranoid and Nimble" and "Well Documented and Pedantic" with the second one being the only one possible in his view once a business gets to a certain size.
• On the subject of Government Sponsored Enterprises (GSEs like Fannie Mae and Freddie Mac) Chris said that the role of these will be up for review by the end of 2011. He thinks that the banks will head back towards actually holding mortgages and loans and the GSEs will become more conduits rather than direct sources of finance. This was news to me, given that so far the GSEs have been notably left out of recent reviews of what went wrong with the recent crisis.

Panel was very good, all speakers very knowledgeable. "Regulation is not risk", "models are not perfect", "risk governance" and "take control of your data" were all themes that echoed last week's RiskMinds event, allbeit with more of an American rather than international viewpoint on the economy, regulation and markets.

RiskMinds 2010 - Day 3 - Financial Engineering Blueprint

Panel moderated by Ricardo Rebanato of RBS on "Determining The New Blueprint For Financial Engineering". It seems like Ricardo has been busy following up on his talk from last year (see post) with the release of his book on scenarios (no I am not on commission for this but thought it may be interesting to take a look at!).

Summary of main points from the panel debate:

• Regulators would like simpler models but simpler does not mean better, complex models do not mean worse.
• It is the thoughtful application of a model that is important, not the level of complexity in itself.
• Given the more complex world we live in, more complexity in modelling is both needed and desirable if things are to improve in risk.
• Some members of the panel thought that regulation had stifled innovation in risk models (as opposed to valuation models) through insisting on conformity of reporting. The innovation is limited since the regulators simply set the rules and then the game begins of the bank optimising against these rules.
• Evan Picoult of Citi disagreed with this, saying that his own group now look at historical events going back over 100 years for possible scenarios as opposed to the last few years (comment: interesting to see someone using more history as a complement to more forward-looking risk modelling)
• Riccardo asked whether there is a conflict between what a regulator wants (lack of risk) and what a rational CEO wants - should a CEO for example accept a level of risk of disaster for the bank of 1 in 50. Evan argued that the banks should be more transparent to allow investors in bank stock and bonds to decide and price-in the policies implemented by bank management.
• Only around 15% of the audience thought that greater pricing/valuation model validation would have changed the 2007-2009 crisis. John Hull said that he had received many emails trying to apportion blame in this way which he rejected. Concensus seemed to be the route cause was the lack of common sense over the mortgage market.

Good debate with Riccardo doing more than just moderating, but not a great deal new relative to recent years. In summary my feeling for RiskMinds 2010 was high quality speakers but a little subdued from the embarassment of 2008 and the anger against the regulators in 2009. Maybe we should all want more subdued risk management conferences but it will be interesting to see what 2011 brings and whether energy levels are up.

RiskMinds 2010 - Day 2 - Perceptions of Risk

Very interesting presentation by David Spiegelhalter of Cambridge University on "Perceptions of Risk - Communicating Risks and Deeper Uncertainties In Words, Numbers & Pictures". David is the Winton Professor for the Public Understanding of Risk, Department of Mathematics at Cambridge University and is involved with the website understandinguncertainty.org.

David started by saying that when communicating risk what is needed is a user-friendly, easy to understand unit of risk. One example he gave was a one in a million change of death, which he termed a "micromort". He said that on average around 50 people a day die of unnatural causes in England and Wales every year, so this means that with a population of 50 million a person's exposure in England and Wales is 1 micromort. He then compared various means of transport and the distance that would need to be travelled to reach a 1 micromort measure:

• Walking - 12 miles
• Cycling - 20 miles
• Car - 217 miles
• Motor Bike - 6 miles

So I guess those of you with motor bikes should take note above!

He emphasised that also peoples reaction to risk is very interesting, and gave the example of a UK health official recently sacked for suggesting that the hobby (addiction?) to horse riding (he termed it "equesy") was just as risky as taking the drug ecstasy - statistically what the official said stacked up but it was simply not culturally acceptable to suggest such an association. No great advertisement for the NHS, but there are around 3753 deaths a year with an average of around 135,000 people in hospital at any one time. This works out at around 75 micromorts if you are in hospital which is around twice the level faced by troops in Afghanistan!

Obviously the above has a number of biases, but David was trying to illustrate how to compare risks and how people are not used to assessing them objectively. In particular, given a choice between probabilities of 1 in 10, 1 in 100 and 1 in 1000, around a quarter of the public would choose 1 in 1000 as the highest probability given it contains the "highest" number.

Whilst the above refers to the denominator with a constant numerator, given the choice between drawing from a bowl containing 1 sweet and 8 marbles and another bowl containing 5 sweets and 45 marbles, 53% of people choose the one containing 5 sweets (because it contains "the most" chances of getting a sweet).

David went on to test the audience on a few trivia questions using what he termed a "quadratic scoring" scale that asked the participant to select a multi-choice answer but to also associate a level of confidence with it. If right and confident the marks given would be high, but if wrong and confident the penalty mark would be much larger. He said that such scoring often produced interesting results and changed people's views, often with young men doing worse (testosterone not being good for risk seemingly!).

He showed how probability density seemed to better understood if represented by density of ink rather than the usual bell curves etc. He suggested that results should come with some more warning of how reliable they are to stop simple acceptance of the numbers reported as "truth". He described how risk is measurable whereas uncertainty is not, which led to the inevitable references to the wisdom (?) of Donald Rumsfeld.

Good fun talk with some great points to make - how humans (and bank management boards?) understand risk is interesting and to some extent surprising (see earlier post for a different slant on human perception of maths). Obviously it is accepted now that simple VAR measures are not enough, but even with the move towards scenario based methods then how to produce a simple but meaningful summary of risk for management is still challenging.

RiskMinds 2010 - Day 2 - Hugo Banziger - New Risk Management Agenda

Hugo Banziger of Deutsche Bank gave a presentation entitled "Reshaping The New Agenda for Risk Management".

Hugo started by saying by outlining the ways in which regulation is changing the markets. Whilst positive overall on the benefits of regulation, he expressed surprise at the regulation on OTC derivatives which he say as helpful in managing risk, and not the cause of the crisis.

He emphasised that whilst regulation is important, that regulation should not be a substitute for risk management and said that regulation in particular does not address:

• The quality of assets held
• The quality of management
• The quality of infrastructure

He additionally mentioned that whilst welcoming Basel III, the economic effect will be to make the supply of credit more expensive to the detriment of economic growth in the real economy.

Given the quality issues he identified above, he then moved on to show what he had done about them in terms of:

• People - what quality of people do you have?
• Processes - where are the holes that things will fall through?
• Systems - can you get a complete picture of risk?
• Portfolio Level Risk - across all asset classes and business units

On people, he advocated a "home grown" risk management team, with people rotated across different roles within risk. He takes the fact that other institutions hire his staff as a frustrating complement to Deutsche Bank risk management. He has implemented a "passport" for his staff which shows what they are trained/competent in and how they are annually tested against this, across both technical and softer management skills. He was funny and quite dismissive that if "anyone does not know what an option is and how it works they are out!" even for lawyers as well as risk managers.

On processes, he has set up a new "risk operations" centre of competence to centralise form filling for risk managers, enabling risk managers to spend more time on risk and less on admin. He stated flatly that just because you find that risk managers spend 50% of their time on admin does not mean you have to accept this and you can do something about it. He also said that he is moving the jobs to where the people are, rather than asking people to move (e.g. risk centre in Berlin to catch Berlin maths graduates).

On systems he has spent EUR30 million in 20 months on sorting out the consistency of data and models within market risk. During the crisis it took DB 48 hours to pull together their mortgage portfolio exposure which was too long. He says that initiatives like this are part of a 10 year investment in systems, data and analytics. His ultimate aim is to have an interactive real-time control centre for all risks in the bank and to move away from paper-based daily reporting. He also mentioned that he had grown his market risk team from 70 to 200 post-crisis.

On Portfolio Risk he says that more time needs to spent on knowing risk apetite and knowing how this fits against risk capacity for the bank. He emphasised that risk managers are there to defend P&L and not capital. He said that portfolio/business model risks were his biggest source of risk.

Inspiring speaker, very confident, open about past losses and mistakes made. Biggest difference to many speakers here was that he put forward tangible actions to address things such as risk culture rather than just talking around them.

 

RiskMinds 2010 - Day 2 - Paul Embrechts on Financial Engineering

I started the day with a presentation by Paul Embrechts (see previous RiskMinds post here) entitled "Financial Engineering And The Financial Crisis: Warnings, Guilt and Lessons Hopefully Learned".

Paul first pointed out that if ever there was a bubble, it was a "bubble" of books on the crisis and its causes. He listed a number of reasons for the crisis, most interesting/new of which was in addition to "too big to fail", was "too big to save" as a new risk given the size of some financial institutions relative to the economies they operate in. Paul has an extensive academic background in both financial risk management and actuarial studies, and I guess it was with his actuary hat on he said that the three main problems for financial engineers going forward were "social insurance, social insurance and social insurance".

By social insurance Paul was referring to medical, life and health insurance and saw this as his big concern for the future. He illustrated this through showing the age distribution of the Japanese population from 1950, 2007 and 2050. Basically the 1950 distribution was like a pyramid with a very young population underneath the middle and old-aged. This shape changed to being fatter in middle age for 2007, and is predicted to be inverted with more older people that younger in 2050. Given that this will result in a percentage reduction of more than 10% in working population supporting an increasingly older population it was not difficult to see what he was meaning.

Paul spent some time going through old papers from him and others (particularly Joseph Stiglitz on securitisation in 1992) warning of the 2008 crisis - I do not know his work well enough to know how much this was "wise after the fact" but what he mentioned on securitisation and correlation made sense given what has since happened. Worth taking a look on his website for some of his papers on Basel and risk management I guess.

One key point he made was simply about volume. Working admittedly on a notional basis, he said that having an OTC derivatives market with notional value of $583 trillion is interesting in the context of a world economy with GDP of only $58 trillion. Even netting notional down you get around $30 trillion of OTC derivatives which still deserves our attention and our efforts to make things better in risk management. I guess his simple message here was "pay attention to volume".

He said the use and abuse of the Repo 105 rule was worth looking at (so I will, anyone with knowledge please let me know), and also questioned the societal benefit of high frequency trading (HFT). Looking back at the Flash Crash Paul said that this was a new kind of risk for risk managers and he had no idea how to hedge it.

Paul defended mathematics as the solution to some of the problems of the crisis and not as the cause - fundamentally he thinks the press have given maths bad PR. He said that we should all watch out for the word "new" being used, as this indicates the start of a bubble with phrases such as the "new economy". Overall a great speaker very comfortable with his subject matter.

 

 

 

RiskMinds 2010 - Day 1 - Risk Governance

I am over in Geneva at the moment (taking a break from the harsh English winter?..) for the RiskMinds 2010 event. Despite its slightly pretentious title (I leave it to you to assess how appropriate the name seemed in 2008...) it is one of the best attended risk management events where risk managers discuss what is going on and what is new to risk management. You can find some posts from the 2009 event here, and the 2008 event here - both make interesting reading given that we are out of the crisis now (aren't we?).

I arrived late for the first day, just to catch a panelist Pippa Malmgren of the Canonbury Group saying that during the crisis everyone knew they were long highly leveraged, very risky assets that were potentially in a pricing "bubble" but when asked about whether this bubble, most used one of the three responses:

• Asset managers said it didn't matter so long as all of our peers go down too...
• Hedge fund managers said that there business was to surf market waves and they could restart the fund afterwards anyway...
• I know it's a bubble but I will be able to get out before it bursts...

Pippa added that the last was the most worrying response, although I guess all are still relevant negative insights into the attitudes of some financial market participants.

The next panel was on Risk Culture & Ethics with Richard Evans  of Citi first up presenting on issues resulting from the crisis. Richard suggested that the following key issues were missed during the crisis:

• Silo Mentality - Risk reports were not comprehensive enough, covering all assets, regions and business units in one; risk management focussed too much on validating individual deal flow (transactions) rather than the portfolio; there were no incents for business managers to share resources and information.
• Short Term Revenue Focus - Focus was on short-term bonuses were not related to profitability after costs and cost of risk capital were taken into account.
• Backward-Looking Models - Models looked backwards (historic VAR for instance) rather than being forward-looking, scenario-based. Richard said that Citi now combine both backward-looking VAR and multiple (severe) scenarios on an approximately 50-50 basis when assessing overall risk now.
• Poor Teamwork - Trading and risk management staff did not work together effectively during the crisis. Richard now suggests this must be addressed through greater involvement of the business in risk management, the introduction of the risk committee and fighting against risk management "ivory towers".
• Board Weakness - Richard said that boards and senior management committees were not set up to react to "alarm bells" such as triggers resulting from limit breaches; Also many boards were simply very weak in their basic understanding of the risks being taken by the business.

I don't think the above will come as any surprise to anyone who has followed the crisis but Richard is a good speaker and so his presentation was entertaining. He later went on to criticise regulators for asking him to replace staff members with 20 years experience with others with 20 years experience - he said that he had not yet found a way to cram 10 years experience in 2 years although maybe recent times have come close to this aim! He also said that firms where the "mood" of the CRO affected what approval decisions were made obviously did not have strong enough governance in place. Richard wants risk and trading staff to work closer together, although he admits that two years on it is difficult to get business level compensation to get traders to work in risk - in this regard he also mentioned his days at JPMorgan when trading and risk staff spent time seconded to the regulators for a time.

There were a variety of other speakers during the day, all dealing with risk governance and culture. Whilst vital to the changes that must be made in the culture of the majority of institutions, I think it is a difficult topic to talk about, since it is hard to express just what needs to be "done" in some pragmatic way. Put another way, the conversations on this topic tend to focus on the need for a risk management culture and become very wooly when discussing how one is implemented. A presentation by Alden Toevs of the Commonwealth Bank Australia attracted discussion by some of the attendees over coffee. The presentation was about how to formalise/make a process of the discussion and agreement of risk appetite (a Risk Appetite Statement) between board, risk management and the business. Alden suggested that the use of anonymous "voting" technology at board level encouraged more openness and discussion, and getting the business involved in this process was a great way to encourage the involvement of trading in risk management. A good presentation in both content and effects (an iMac user I think!) and an amusing speaker who pointed out that visiting the Australian parliament is interesting for a risk manager given that you are surrounding by genuine Black Swans in the lake outside...

 

 

 

 

The current bad luck of the Irish

If like me you are puzzled as to:

• Why the Irish need a financing package now when they don't need to borrow for at least another 6 months?
• Why adding more debt on top of bad debt makes things better?
• Why bondholders of failed banks don't get forceably converted to holding equity and original equity holders get nothing?

Then take a read of the this article from the FT. We live in interesting economic times.

Risk USA - 15 cents in the dollar isn't good...

I went along to the Risk USA event yesterday and caught a good panel in the afternoon called “Garbage in, garbage out” Servicing the data supply and analytic needs for risk management.

In particular, one of the speakers, Frank R. Brown, described some work he had done as a consultant at one financial institution on tracking and rebalancing an index product. To do this, Frank had to integrate the constituent instrument symbology of the:

• Custodian
• Index Provider
• Real-Time Data Provider
• Rebalancing Software
• In-house Trading System

On top of this, corporate events might result in changes to symbology that not all providers would be up to date on, with various lags before all had caught up with the corporate action (rebalancing software often late, custodian often not changing symbol at all). He mentioned that he did all of this symbology management manually in Excel.

Of his time, he said he spent:

• 65% on managing the symbology and dealing with data issues
• 20% managing the various vendor APIs in Excel to update the data
• 15% on tracking and rebalancing

To sum up, he said that a productive work level of 15 cents in the dollar wasn't good value for the client and yet the issue continues on and on. I don't think that his example was particularly earth shattering in terms of newness, but it put in a very simple and pragmatic context the importance of doing some of the simple things right and the benefits of a more automated approach to data management, even before you delve into the data quality/validity issues of the market data itself.

Just to end on an entertaining note, then back to the title of the talk on "Garbage-in, garbage-out..." the panel moderator (Domenic Iannaccone of Sybase) put forward a good quote he had heard:

"If everyone used the same garbage at least that would be a step forward!"

Transparency and consistency can take many forms, but I didn't know it needed to apply to incorrect data too!...

 

A French Slant on Valuation

Last Thursday, I went along to an event organized by the Club Finance Innovation on the topic of “Independent valuations for the buy-side: expectations, challenges and solutions”.

The event was held at the Palais Brongniart in Paris, which, for those who don’t know (like me till Thursday), was built in the years 1807-1826 by the architect Brongniart by order of Napoleone Bonaparte, who wanted the building to permanently host the Paris stock exchange.

Speakers at the roundtable were:

• Eric Benhamou, CEO  Pricing Partners
• Francis Cornut, Président  DeriveXperts
• Jean-Marc Eber, Président LexiFi
• Patrick Hénaff, Associated Professor at the University of Bretagne (see model validation paper for additional background)
• Claude Martini, CEO  Zeliade Systems

The event focussed on the role of the buy-side in financial markets, looking in particular at the concept of independent valuations and how this has taken an important role after the financial downturn.  However, all the speakers agreed that remains a large gap between the sell-side and buy-side in terms of competences and expertise in the field of independent valuations. The buy-side lacks the systems for a better understanding of financial products and should align itself to the best practices of the sell-side and bigger hedge funds.

The roundtable was started by Francis Cornut of DeriveXperts, who gave the audience a definition of independent valuation. Whilst valuation could be defined as the “set of data and models used to explain the result of a valuation”, Cornut highlighted how the difficulty is in saying what independent means; there is in fact a general confusion on what this concept represents: internal confusion, for example between the front office and risk control department of an institution, but also external confusion, when valuations are done by third-parties.

Cornut provided three criteria that an independent valuation should respect:

• Autonomy, which should be both technical and financial;
• Credibility and transparency;
• Ethics, i.e.: being able to resist to market/commercial pressure and deliver a valuation which is free from external influences/opinions.

Independent valuations are the way forward for a better understanding of complex, structured financial products. Cornut advocated the need for financial parties (clients, regulators, users and providers) to invest more and understand the importance of independent valuations, which will ultimately improve risk management.

Jean-Marc Eber, President LexiFi, agreed that the ultimate objective of independent valuations is to allow financial institutions to better understand the market. To accomplish this, Eber pointed to the fact that when we speak about services to clients, we should first think of what are their real needs. The bigger umbrella of “buy-side” implies in fact different needs and there is often a contradiction on what regulators want: on one side, having independent valuations provided by independent third parties; on the other side, independent valuations really mean that internal users/staff do understand what there is underline the products that a company have.In the same way, we don’t just need to value products but also measure their risk and periodically  re-value them.It is important, in fact, to have the whole picture of the product being evaluated in order to make the buy-side more competitive.

Another point on which the speakers agreed is traceability: as Eber said, financial products don’t exist just as they are, but they go under transformation and change several times. Therefore, the market needs to follow the products across its life cycle till its maturity stage and this pose a technology challenge, in providing scenario analysis for compliance and keeping track of the audit trail.

At the question, ‘what has the crisis changed’ panellists answered:

Eber: the crisis showed the need to be more competent and technical to avoid risk. He highlighted the need to understand the product and its underlying. Many speak of having a central repository for OTCs, obligations, etc but this needs more thinking from the regulators and the financial markets. Moreover, the markets should focus more on quality data and transparency.

Eric Benhamou, CEO pricing Partners, sees an evolution of the market as the crisis showed underestimated risks which are now being taken in consideration.

Claude Martini, CEO Zeliade, advocated the need for financial markets to implement best practices for product valuations: buy-side should apply the same practices already adopted by the sell-side and verify the hypotheses, price and risk related to a financial product.  

Cornut admitted  things have changed since 2005, when they launched DerivExperts and nobody seemed to be interested in independent valuations. People would ask what value they would get from an investment in independent valuations: yes, regulators are happy but what’s the benefit for me?

This is changing now that financial institutions know that a deeper understanding of financial products increases their ability to push the products to their clients. The speech I enjoyed the most was from Patrick Hénaff, associated professor at the University of Bretagne and formerly Global Head of Quantitative Analysis - Commodites at Merrill Lynch / Bank of America.

He took a more academic approach and contested the fact that having two prices to confront is thought to reduce the incertitude on the product but highlighting as this is not always the case. I found interesting his idea of giving a product price with a confidence interval or a ‘toxic index’ which would represent the incertitude about the product and reproduce the model risk which may originate from it.

We speak too often about the risk associated to complex products but Hénaff, explained how the risk exists even on simpler products, for example the calculation of VAR on a given stock positioning. A stock is extremely volatile and we can’t know its trend; providing a confidence interval is therefore crucial. What is new instead, it is the interest that many are showing in assigning a price to a determinate risk, whilst before model risk was considered a mere operational risk coming out from the calculation process. Today, a good valuation of the risk associated to a product can result in less regulatory capital used to cover the risk and as such it is gaining much more interest from the market.

Henaff describes two approaches currently taken from academic research on valuations:

1) Adoption of statistic simulation in order to identify the risk deriving from an incorrect calibration of the model. This consists in taking historical data and test the model, through simulations and scenarios, in order to measure the risk associated in choosing a model instead of another;)

2) Have more quality data. Lack of quality data implies that models chosen are inaccurate as it is difficult to identify exactly what model we should be using to price a product.

 

Model risk, which as said above was before considered  an operational risk, now becomes of extremely importance as it can free up capital. Hénaff suggested that is key to find for model risk the equivalent of the VAR for market risk, a normalized measure. He also spoke about the concept of a “Model validation protocol”, giving the example of what happens in the pharmaceutical and biologic sectors: before launching a new pill into the market, this is tested several times.

Whilst in finance products are just given with their final valuation, the pharmaceutical sector provides a “protocol” which describes the calculations, analysis and processes used in order to get to the final value and their systems are organized to provide a report which would show all the deeper detail. To reduce risk, valuations should be a pre-trade process and not a post-trade.

This week, the A-Team group published a valuations benchmarking study which shows how buy-side institutions are turning more and more often to third-parties valuations, driven mainly by risk management, regulations and client needs. Many of the institutions interviewed also admitted that they will increase their spending in technology to automate and improve the pricing process, as well as the data source integration and the workflow.

This is in line on what has been said at the event I attended and confirmed by the technology representatives speaking at the roundtable.

I would like to end with what Hénaff said: there can’t be a truly independent valuation without transparency of the protocols used to get to that value.

Well, Rome wasn’t built in a day (and as it is my city we’re speaking about, I can say there is still much to build, but let’s not get into this!) but there is a great debate going on, meaning that financial institutions are aware of the necessity to take a step forward. Much is being said about the need for more transparency and a better understanding of complex, structured financial products and still there is a lot to debate.  Easier said than done I guess but, as Napoleon would say, victory belongs to the most persevering!

Analytics Management by Sybase and Platform

I went along to a good event at Sybase New York this morning, put on by Sybase and Platform Computing (the grid/cluster/HPC people, see an old article for some background). As much as some of Sybase's ideas in this space are competitive to Xenomorph's, some are very complimentary and I like their overall technical and marketing direction in focussing on the issue of managing of data and analytics within financial markets (given that direction I would, wouldn't I?...). Specifically, I think their marketing pitch based on moving away from batch to intraday risk management is a good one, but one that many financial institutions are unfortunately (?) a long way away from.

The event started with a decent breakfast, a wonderful sunny window view of Manhattan and then proceeded with the expected corporate marketing pitch for Sybase and Platform - this was ok but to be critical (even of some of my own speeches) there is only so much you can say about the financial crisis. The presenters described two reference architectures that combined Platform's grid computing technology with Sybase RAP and the Aleri CEP Engine, and from these two architectures they outlined four usage cases.

The first use case was for strategy back testing. The architecture for this looked fine but some questions were raised from the audience about the need for distributed data cacheing within the proposed architecture to ensure that data did not become the bottleneck. One of the presenters said that distributed cacheing was one option, although data cacheing (involving "binning" of data) can limit the computational flexibility of a grid solution. The audience member also added that when market data changes, this can cause temporary but significant issues of cache consistency across a grid as the change cascades from one node to another.

Apparently a cache could be implemented in the Aleri CEP engine on each grid node, or the Platform guy said that it was also possible to hook in a client's own C/C++ solution into Platform to achieve this, and that their "Data Affinity" offering was designed to assist with this type of issue. In summary their presentation would have looked better with the distributed cacheing illustrated in my view, and it begged the question as to why they did not have an offering or partner in this technical space. To be fair, when asked whether the architecture had any performance issues in this way, they said for the usage case they had then no it didn't - so on that simple and fundamental aspect they were covered.

They had three usage cases for the second architecture, one was intraday market risk, one was counterparty risk exposure and one was intraday option pricing. On the option pricing case, there was some debated about whether the architecture could "share" real-time objects such as zero curves, volatility surfaces etc. Apparently this is possible, but again would have benefitted by being illustrated first as an explicit part of the architecture.

There was one question about the usage of the architecture applied to transactional problems, and as usual for an event full of database specialists there was some confusion as to whether we were talking about database "transactions" or financial transactions. I think it was the latter, but this wasn't answered too clearly but neither was the question asked clearly I guess - maybe they could have explained the counterparty exposure usage case a bit more to see if this met some of the audience member's needs.

The latter question on transactions above got a conversation going on about resilliancy within the architecture, given that the Sybase ASE database engine is held in-memory for real-time updates whilst the historic data resides on shared disk in Sybase IQ, their column-based database offering. Again full resilience is possible across the whole architecture (Sybase ASE, IQ, Aleri and the Symphony Grid from Platform) but this was not illustrated this time round.

Overall good event with some decent questions and interaction.

Dodd Frank Regulation - being seen to be doing something?

I went along to a Six Telekurs event "Securities Valuations: Is the Price Right?" last week - good event with some interesting speakers, most notably Paul Atkins of Patomak Partners to talk about the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. Paul is based out of Washington and was not very complimentary about what has been going on.

He started by saying that the Act was very large in size, with over 2319 pages (compared to SarbOx with only 60) and given this size he suggested that you could guess how many in Congress had actually read it. Background to the Act were:

• "Political Tailwinds" such as:
  • New Democrat Government with tenuous majority
  • Ambitious legislative plans
  • Bleak economic back-drop
• An angry populace:
  • TARP bailouts/Wall St bonuses
  • Recession and high unemployment
  • Perception that Govt. contributed to crisis
• Aggressive case for new regulation based on:
  • Lack of confidence in current systems and regulation
  • "Too big to fail" demonstrating that regulators lack the toolsets necessary to deal with such events
  • High leverage across the financial system and the economy
  • Poor risk management by existing participants
  • Opaque shadow banking system and opaque derivatives markets

He summarised that Housing and the Credit Rating Agencies were the key fundamentals behind the financial crisis.

Paul said that with the new regulation had the following features:

• The Act is a sweeping revision of financial regulation in the US
  • few dodged the regulatory changes (notably insurance managed to do this)
• The Federal Reserve has emerged pre-eminent amongst all regulatory bodies in the US.
• Significant discretion has been yielded to regulators to work out specifics
• Sheer size and ambiguous wording of the Act exacerbates the uncertainty in the market and economy and will require further fixes over coming years
• The Act does not reform Government Sponsored Enterprises (Fannie Mae, Freddie Mac)
• Far from reducing/simplifying the number of agencies involved in regulation the Act eliminated 1 agency and created 13 more
• Paul asked the question whether spreads and volatility will rise in the market due to new regulation (such as the Volcker rule) and whether ultimately this will trickle down to hinder or benefit SMEs.
• The Act will likely result in regulatory arbitrage opportunities and Paul said this was not a good thing for the United States

Paul said that in his view Congress learned the wrong lessons from the crisis:

• No reform of Fannie Mae and Freddie Mac
• Government Housing Policy left unaddressed
• Transparency still lacking despite efforts from FASB on fair value
• International Policy Co-ordination is still an open question as to its extent
• No reform of existing regulator structures
• The crisis has resulted in payoffs to favoured groups (Unions, Trial Lawyers etc)

Paul talked about how hedge funds and private equity funds were going to experienced increased regulation with them having to register if they have over $100M assets under management and future implications for systemic risk provisions. He mentioned that Venture Capital investments had escaped being required to register if the lock-up period was over 2 years.

He briefly discussed the coming changes in OTC derivatives on centralised clearing, post trade reporting and new liability provisions. Paul was also concerned about certain SEC related issues such as "Whistleblower" provisions which contain a bounty programme of about 10-30% of any fine subsequently awarded against a financial institution. He re-iterated that it was not yet clear what all of the bodies involved in regulation would be doing, and at the same time as this was the case the very same bodies were also being given very strong powers such as that of legal subpoena.

Paul was a very knowledgeable speaker and had some good points to make. Listening to him speak it would seem from my perspective that the Act is a prime example of "being seen to be doing something" to address the crisis rather than something better structured, with all of "law of unintended consequencies" risks that such an initiative entails.

 

 

 

Moving to America - people great, bureaucracy less so...

Apologies that there have been few blog posts lately. Summer has been very busy as I have just moved to the New York area with my family. Whilst we had to do a lot of preparation with going to the US embassy etc for visas, the move finally became "real" for me when all of the furniture in our house was removed for shipping to the US, and we ended up effectively camping in our own home for a few weeks. The day of the flight over seemed like the start of a holiday, except it became a peculiar one in that we weren't coming back any day soon.

I am pleased to report that all has gone well and that people here have been very welcoming. Kids settled into school fine and are already developing strange mid-Atlantic accents. I am enjoying walking down the street and saying "hello" to people without fear that they will avert their eyes and simply look down at the floor - one of the worst parts of stereotypical English behaviour in London.

There are many things that the Americans do wonderfully well: seriously huge lorries that actually look like my old Tonka toys; double/triple/quadruple garages; bathrooms; walk-in wardrobes; metros that announce "Stand away from the closing doors" in a voice that is both pleasant and excited at this fact - much in contrast to the depressing "Mind the gap, mind the gap" of the London Underground.

Putting aside all these positives (the people being the biggest positive), there are some things that are puzzlingly not done well at all. On using my American bank account I wanted to set up a regular monthly payment to my landlord. After initially being told that this could not be done, I then get directed to part of the bank web site where I am told to enter my landlord's name and address, but nothing more. Puzzled I ask whether they also need his bank account details, but apparently not, because each month on the day I have chosen they will physically print off a cheque for the amount I have specified and physically mail it to him! So much for the land of technology and financial innovation?...

Anyway, on to the pinnacle of bureacracy here in the United States, the Department of Motor Vehicles (DMV). DMV sounds like a disease and indeed I believe that all who work there are obviously ill in some way. Buying a car in the US is complicated process if you are not a US citizen and do not yet have a Social Security Number (SSN). I spent around 18 hours of my life queuing trying to get license plates for my car at the DMV, being told to move from one queue to another with no rhyme nor reason, and often to be told after queuing for a few hours that I was in the wrong queue. These people make US Immigration at JFK look positively helpful and friendly. The one consolation? They treat their fellow Americans just as badly as they treat foreigners, so once I was through the first few hours there were plenty of people wanting to talk about how bad it was.

Anyway, back to the real (currently surreal?) world of financial markets and financial markets IT. I hope you had a good summer, mine has been an interesting one and I look forward to the next couple of years in the United States of America.

Transparency Regulation is not Transparent.

Decent FT article on the problems with the transparency of stress testing of financial institutions in Europe.

Active to Passive and Back Again

FT article saying that passive fund management is set for growth giving the disillusionment of investors with the benefits of active fund management. Interesting piece was the bit where the growth in index-based investment may ultimately introduce index-inclusion distortions in constituent pricing, so ultimately swinging round to benefit those active fund managers that are still around to see this. Makes sense as there is always some money to be made (and lost!) when everyone starts to do the same thing, or maybe I am already being taken in by the forward-looking PR departments of the active fund managers?...

The Humans Between Risk and Data

Some of my thoughts on risk management, data management and human behaviour, are to be found on page 20 of the Inside Reference Data Special Report "Managing Risk"

A Crisis Needs a Utility?

I heard Francis Gross of the ECB speak at one of the panel events at the XTrakter Conference last week, and found that I couldn't avoid asking him whether the aims of the "Data Utility" initiative by the ECB could be better separated from the means by which the ECB proposes to solve them. At the moment, reference data issues for the industry and the data utility seem to be presented as a single "package". I can't say that the response to my question was a clear one to my understanding; however I would say that Francis was helpful after the panel had finished and provided a recent presentation of their ideas, of which you can find a copy here.

Looking through the presentation, the motivations put forward for why the industry needs a data utility seem to include:

• Data processing must be done in an automated manner, since data volumes have moved beyond the capabilities of manual processing.
  - can't see anyone arguing with this
• Data is a major bottleneck, with multiple providers/sources each with the own "data dialect"
  - agreed and to some extent what keeps data/data management vendors in business, but sounds sensible to standardise if possible as there are plenty of other problems to address
• These data dialects lead to increased cost, operational risk and reduced responsiveness
  - agreed, mainly a cost aspect I would suggest
• The recent crisis was not helped by weak data management in the industry
  - but nor was it the cause, so not a great premise for a data utility
• • lack of transparency of data
    - "transparency" is an over-used word at the moment, but certainly clarity and quality were/are needed
  • systematic risk could not be assessed due to the availability of data
    - using terms like "systematic risk" seems to imply the regulators could calculate something, whereas this discipline is new so I guess we are really talking about simply knowing who is exposed to who and how.
• We need the capability to run large scale computing analysis on a vast pool of micro data, sometimes on an ad-hoc basis when a crisis begins
  - fundamentally agreed but also good to qualify with what you propose to be calculated - having a set of "numbers" doesn't seem to have helped much recently...

I started the above bullet point list by saying it contains the motivations for "why the industry needs a data utility" but I guess looking at the above list they really point to the more general aim of "why we need better industry-level data management". In the presentation the above points are then used to state:

"We all need the same good basic reference data. Why build more than one infrastructure?"

Maybe "Why build more than one infrastructure?" should really be changed to say "Why maintain more than one infrastructure?" given that Bloomberg, Thomson Reuters, Six Telekurs, Interactive, Markit and all the other vendors already infrastructure to do this. Not sure if I should read anything into the wording but more logical leaps of faith are to follow.

The presentation then moves on to state that shared reference data standards are a must, to which I cannot see many consumers of data disagreeing with that statement. Not sure I agree though with the overly simplistic statement that "Data will be good for all users or good for none". Trying telling that to the accountancy and risk departments for example but I suppose what we are talking about here is basic reference data not the more subjective price and valuation data. Reference data on instruments and entities is either right or wrong, and the presentation makes the good point that no amount of "data cleaning" can help this i.e. if wrong, the data needs to be re-captured from an accurate source.

The call for the establishment and use of reference data standards in the presentation then seems to be used to "slide "into a call for a standard reference data infrastructure. Unless I am very much mistaken, these two things are not necessarily the same thing and so it seems a logical leap has been taken here. The presentation talks about the possible necessity of "top down" legal compulsion for the industry, again something that I could agree and see the need for, but both the issues and legal compulsion do not automatically drive us to a "data utility" as the only option? Why couldn't legal compulsion be applied to the existing data vendors to standardise on common IDs for instance? ISIN is proposed as a standard in the presentation, but I can only assume that this is due to the ECB being mainly focussed on the bond world where to a large degree ISIN's work (i.e. are unique), whereas in the world of equities ISIN needs a lot of qualification (currency, exchange, share class...) before it uniquely identifies a quoted equity.

In summary, the presentation starts with showing how great the ECB's Centralised Security DataBase is (7 million securities, 3 million record updates/day etc...) and it does look good. The data issues for the industry seem clear, although I think the "crisis" is a bit of a red herring to the aim of data cost reduction, however the logical jump from industry need to effectively "we must have a data utility" is an interesting one, one where I would prefer that more options were discussed. It seems ironic that in these days of "transparency" it is not at all that transparent to me why more alternative solutions are not being discussed and a choice justified. Talking of choice and as a final thought, I am also not sure why the data vendors are not up in arms about this initiative - are they frantically lobbying behind the scenes? - do they simply think the utility won't go ahead? - or are they afraid of upsetting the EU? Any insight is very welcome, and maybe more of update from me when I get chance to speak with Francis in more detail.