RiskMinds - VaR as simple as chartism?

Interesting panel debate at RiskMinds Wednesday morning, entitled "Sophisticated Complex Models vs. Crude Robust Risk Measures".

Riccardo Rebonato of RBS started off the debate in (untypically?) controversial style by saying that he thinks that the risk management models (mostly VaR) used in financial markets are peculiar. Peculiar in that coming from a physics background he is used to models that have "causal" links between inputs and outputs, whereas VaR is based simply on the P&L distribution of a portfolio i.e. all the information is contained in the data itself. Riccardo said the obvious analogy was with chartism, where decisions are made on the observed market data itself without any reference to external (exogenous) factors at all (perhaps he should have a discussion on endogenous risk with Jean-Phillippe Bouchard at Quant Invest). Riccardo suggested that in the range of models from those that are "over specified" with two many inputs to those in "reduced form", then VaR was far too much at the reduced form end.

In response to Riccardo's proposal that risk models should involve more causal ("factor") effects, Andreas Gottschling of Deutshe Bank countered with the quote from Harry S. Truman "Give me a one-handed economist! All my economists say, On the one hand on the other.". To which Riccardo acknowledged that maybe Economists and Econometrics were less suited to trading/analyst reports (e.g. give me a single view of what the prospects/returns will be) and more suited to risk management (e.g. give me a range of scenarios with supporting assumptions for each).

Chris Finger of RiskMetrics moved on to put forward an argument for standardisation of risk reporting, saying that it was impossible to say what methodology was behind the VaR numbers disclosed by major financial institutions. He proposed that risk reporting needed to be standardised and obligatory, but emphasised that risk management should not standardised. Paul Shotton of UBS agreed, saying that whilst micro-prudential risk of Pillar I had decreased risk on an individual institution level, it had increased systematic (macro) level risk and this was an area of failure for the regulators. On this the panel agreed, echoing a lot of what Avinash Persaud said in proposing the more diversity of risk management was highly desirable.

On standardisation, Riccardo noted that many banks had switched from using 10-day to adjusting up a 1-day VaR, and as a result presenting a less risky picture to analysts and regulators, regardless of how risky the "tail" of each institutions' P&L distribution is. Riccardo also proposed that there should be "constructive ambiguity" over what is asked of the banks by the regulators - put another way he suggested the regulators should come up with the "curriculum" for risk but not the "questions", as definitive questions encourage arbitrage.

Andreas then brought the debate back to its title, and put forward that maybe VaR should be replaced by simpler measures such as limits on notional traded. Paul suggested that VaR was only good for simpler products and portfolios, under "normal" market conditions. He said that he had been an advocate of more stress testing for a long time as a complimentary approach to VaR, but also combined with the simpler approach of limits.

It was an interesting debate, particularly with Riccardo's proposal on VaR being too simple a measure based on statistics, and wanting a more "causal" model to be developed. Using the example of June 2007, Riccardo said that everyone knew something big was about to happen but this was not reflected in VaR calculations since they are statistically based and inherently backwards-looking and not predictive. The lack of prediction is a very valid point, but putting forward a counter-view, then I get the argument about economists giving a range of outcomes, but surely these should be fed into the scenario engine rather than trying to develop econometric models of relationships between market variables. Econometric models are just as vunerable as any other to the mis-behaviour of markets (anyone seen a stable correlation lately?).

A few of the other risk managers there expressed other views, from the more buy-side folks who were more comfortable with factor-based modelling, to risk managers who said that VaR was already "structural" with explicit relationships between valuations and interest rate inputs for example. It would be good to understand more of Riccardo's ideas on this, since it appeals from making risk a more "forward-looking" process but I find it difficult to quite grasp what "causal" model you can have of markets that is itself robust to changes in market behaviour.

RiskMinds - The Failure of Risk Models

Avinash Persaud of Intelligence Capital gave the opening talk of the morning at RiskMinds (see first of set of posts from last year here) and put forward a lot of the very good ideas that he has contributed to in the recent Warwick Commission Report. Main points that Avinash made:

• Regulators were admirably quick in working out where past regulation had gone wrong in focussing too much on micro (individual institution) rather than macro (whole market)/systematic risk.
• The regulators then came out with promising papers on counter cyclical regulation and other positive ideas.
• These new ideas do not win votes however and do not satisfy the public's desire to punish someone - Avinash called this the "Bad Apple" policy, with "bad bankers, bad products, bad jurisdictions" being the perceived guilty parties.
• All past crises have resulted in demands for three things: i) more risk management; ii) more regulation; and iii) more transparency.
• These are fine as demands but evidently do not prevent financial crises.
• Avinash recalled his work back at JPMorgan in the early 90's when the 4:15 report was produced for Sam Weill, which eventually led to VAR reporting becoming widespread.
• He then fast forwarded to the Asian crisis of 97 where he saw the failings of VAR (or rather its widespread use) first hand with all players using VAR which when volatility increased caused an increase in VAR causing JPM (and all) to sell causing markets to fall, increasing vol causing more selling, increasing correlation and leading to what is called the "loss spiral".
• In light of the recent crisis, Avinash said the public perception is that bankers created a load of toxic bombs (products), through them at an unsuspecting public and ran away...
• ...and in his opinion the reality is that banks created a load of toxic bombs and ran straight towards them i.e. this was a failure of risk management where bankers did not understand the risks they were buying and selling.
• He then took us back to the 1950's and the formation of modern portfolio theory with Markowitz and Danzig working at the RAND Corporation.
• At that time banks and insurers were still separate, with FX and capital controls still in place meaning that not only could the "efficient frontier" of investment portfolios be observed but it could also be acted upon.
• Now everyone has the same information everyone can observe the efficient frontier of investment opportunities but cannot exploit or act upon it, since usually everyone moves in (the "herd") and the value observed is changed by this crowded participation in the market. Here he seems to be echoing a lot of what Bob Litterman said at QuantInvest last week over the "crowded trade" and that the barriers to market knowledge and our ability to act on this knowledge have been lowered forever.
• Avinash put forward that many of the models we use today assume the statistical independence of decision making process whereas the reality is that the market is homogenous (everyone is thinking/acting the same) and hence these models are invalid in this "crowded" context.
• In light of this, the problem of risk management is not about exogenous risk (risks from outside the market, from Black Swan events to normal distributions) but more about endogenous risk i.e. peoples behaviours upon seeing opportunities cause strategic risks. (Interesting given Jean-Phillippe Bouchard at QuantInvest commenting on what makes prices move). Put another way, behaviour is the issue not the financial instruments themselves.
• Avinash proposes that risk capacity (the ability of an institution to absorb a particular type of risk) shoudl be thought through more fully, with for example insurance and pension institutions with long-term liabilities having a much greater capacity to absorb liquidity risk than banks, and banks with short term funding being a better position to manage a loan book.
• He pointed out that regulation that uses market prices to protect us against movements in market prices is doomed to failure before it starts.
• Booms occur due to some perceived "paradigm shift" technolgy leading to dramatically improved risk/return ratios - he cited things such as cars, electricity, rail, dotcom and the mantra from those involved that "This time it is different..." (see "bubble" post from last year)
• Avinash thinks the regulators are significantly to blame for the last crisis since they themselves said the latest financial innovations in credit derivatives were making us safer through sharing out risk in the system.
• He said that there is no theory for making a complex system "safe" as a whole and that the regulators did not/do not "get" this idea.
• Diversity of approach and risks in a large systems (macro financial markets) is our only current defence and regulatory "best practice" has driven conformity not diversity in the market, making systemic risks higher not lower.
• So the regulators are themselves creating a homogenised market.
• In terms of solutions, he proposes that risk and audit committees need separating so that risk management does not become a "tick box" exercise.
• He further proposes that the risk management function is given some capital so that it can place hedges at a macro level for institution (i.e. looking at the resulting risk when divisional risks have been aggregated) - here is proposing moving to risk "management" as opposed to the much more common risk "reporting" found in many institutions.
• One risk management indicator idea he proposed was to put a portfolio management model together that was linked to VAR in order to see where the "herd" is moving to (e.g. low vol, high return Asian markets of the past etc) and to move or hedge against this.
• He is concerned that applying Basel II regulation to the Insurance industry with Solvency II will mean that all players will be dancing to same VAR tune which will introduce more risk as more institutions are forced to react in the same way to market movements and volatility.
• On the same lines, Credit Rating Agency regulation will create barriers to changes in ratings methodology in response to endogenous market risk, again meaning that everyone will be forced to behave and act in the same ways.
• He summarised that "endogenous risk" (movements in the market caused by the market) and not statistical distributions that are the key issue and diversity is the only solution.

Entertaining speaker with some interesting ideas that fly in the face of much of what is being done by the regulators today, and generally well received by many of the risk managers present. Behavioural finance and the "crowded trade" (i.e. everyone doing the same thing in the market causing movements within the market) seem to be key themes occuring in a lot of what academics and practitioners have said on risk management recently. Now what to do about it? Not sure that less (not more) regulation will find many fans at the moment...answers on a postcard please!

Views on Fair Value...

Busy week last week for events in London, this time over at the Goodacre / Six Telekurs on Thursday morning. Guy Sears of the IMA was chair of the event, and the event did have a "buy-side" focus to it. Richard Newbury of Six Telekurs started the event and made the following points on the current state of regulation:

• UCITS IV - Richard cited the stats that there are around 37,500 funds in the EU with average value of approximately $180M each as compared to only 8,000 funds in the US with average value over $1B. Richard said that such a proliferation of funds was costly and the more EU could standardise funds and their ability to be transacted everywhere in the EU the better.
• Reg NMS - Richard took a little humorous dig at US regulators when he reminded us that Congress authorised the SEC to form a "National Markets System" in 1975 and so this had taken around 30 years to implement. Whilst Reg NMS is often compared to MiFID, he said that Reg NMS had led to consolidation in the US while obviously MiFID has led to fragmentation in the EU.
• Hedge Funds - Both EU and US regulators are looking at the hedge fund industry. He mentioned the battle the UK was having with some of the (misguided?) regulation that the EU is trying to introduce with over 30,000 HF related jobs in London. The new regulation is likely to increase reporting requirements leading to more need for regular, standardised fair value reporting.
• Credit Rating Agencies - Richard mentioned how there will be more ratings and more ratings types, and the regulation introduced to ensure the CRA do not fall into the conflict of interest trap.
• Data Management - He mentioned the importance of data management within what is happening in the industry and noted how the profile of data management was on the increase.

Mike Jenkins of Ernst & Young tried his best to make the accountancy treatment of derivatives interesting and didn't do too bad an effort but I only took the following few notes from his talk:

• Unlike US GAAP with FAS 157 there is no single standard Fair Value (FV) definition in IFRS, and unsurprisingly IASB are addressing this.
• Mike spent some time mentioning Level 1(quoted), Level 2 (observable) and Level 3 (unobservable) pricing inputs for securites, taken from the IASB exposure draft ED/2009/5 (also see Rowe in earlier post)

Matthew Cox of BoNY Mellon Security Services then gave his presentation on the difficulties/challenges of providing a valuation service to their asset management clients:

• His division often have a "2 hour" window to produce valuations for NAV reporting, often for a 12 midday valuation
• Data exceptions for investigation went through the roof this year due to increased volatility (comment: didn't get chance to ask whether the validations set were "normalised" for market volatility i.e. a price movement threshold would not be fixed but rather be multiplied by a factor relating to recent volatility levels)
• Matthew was very complimentary about the efforts his team put in to cope with this increase in data exceptions.
• He mentioned how many of his clients of established "Fair Value Committees" over the past couple of years, comprised of staff from compliance, risk management, portfolio management etc.
• Matthew mentioned the importance of time zones in valuation and the timeliness of data, with the availability of intraday CDS prices contrasting with bonds who price only from the evening close of the day before.

The panel debate was moderated by Guy Sears, and included the above speakers plus Nigel Reynolds from TD Waterhouse):

• Matthew said that his division sometimes shared the "consensus" price from other clients when one client is looking for some guidance.
• He mentioned that a key timeframe in establishing FV was establishing what is a "reasonable" time frame for sale of a security.
• Nigel Cox said that "suspended stocks" had been a real issue over the past year, where the client "context" (position, situation etc) would very much determine what value a client would want assigned to a holding.
• Guy Sears suggested that valuations should be provided with a confidence interval and not just as a single price
• Mike of E&Y said that this is what full disclosure now requires, other memberrs of the panel suggested this was realistic but not what clients (humans?) expect to receive - they want a single number.
• Guy wondered whether it was an issue that one entity might value an asset at a value X whilst another would value the liability at Y (not equal to X)
• Mike of E&Y pointed out that this was an issue in that current accountancy rules allow a security to be reclassified from "fair value" pricing to "historic cost" basis - this discretion is being removed in future rule implementations
• One member of the audience pointed out that Bloomberg, Reuters and Markit were all trying to extract more revenue from data used for valuation purposes.
• Matthew advocated that the market needed more competition between niche data vendors such as Markit and SuperDerivatives to ensure innovation in service and more competitive pricing.
• The audience asked Guy of the IMA whether the association should have offered more guidance on fair valuation process and best practice.
• Guy said they have provided some, but he advocated that trade associations should not have opinions, since it was not healthy to have the asset management industry collectively herding towards the same valuations.

Well attended event with some good speakers, particularly Guy Sears as host was funny, knowledgeable and kept the other speakers on their toes. I would say the most interesting point was still that "opinions" form prices, opinions formed in the investment/funding "context" of the party with an interest in valuing a security - conceptually this seem to make the asset servicing companies a little uncomfortable since what they are contracted to do is to provide the "right" set of numbers by their clients. Human beings feel more comfortable fixating on a single number than a range of possible outcomes/results it would seem!...

High Frequency Trading vs Flash Trading

Economist Tim Worstall has an distinction to make on the differences between high frequency trading and flash trading in a recent article.

Essentially it is the difference between getting your orders in quicker than every one else, and having a peek at what everyone else is doing before putting your money down.  The SEC appears to be conflating the two and has concerns.

With the world condition in banking, could we see some poorly thought out legislation rushed through so that regulators can be seen "doing something"?  Or would it level the playing field a little so that those trading operations that cannot afford the overhead of super fast computers and networks are not excluded?

Pricing Model Validation: Mitigating Model Risk

I managed to catch some of the day yesterday at the "Pricing Model Validation: Mitigating Model Risk" conference. I thought it would be worthwhile going along since firstly the past 12-18 months have made model risk very topical (take a look at previous posts from Riskminds, the Modeller's Manifesto and Wilmott/Rowe).

Secondly more of our clients are looking at managing and centralising pricing models/curve calculators in addition to just managing the underlying data (see this Insight Investment client case study for a recent public example). I am calling this "Analytics Management" which is the business-focussed technology stack that combines pricing models/calculators/analytics with all of the "Data Management" underneath. But enough of my thinly-veiled positioning statements...and on with some of the (hopefully) useful content from the conference outlined below - maybe scan the headings in bold below for those talks of interest but I would particularly recommend the ones by Tanguy Dehapiot and Yuyal Millo...

Model Risk 2009 defining and forecasting. First speaker was Professor Phillip Sibbertsen of the University of Hannover on defining and measuring model risk. Phillip started by saying that "Model Risk" was a new category of risk within the confines of "Operational Risk", and that operational risk as defined by the regulators does not yet currently include the "model risk" of market risk and credit risk, nor the "model risk" of the operational risk model itself. (I am sure I could write that up better!...). Phillip put forward that model risk is not formally a "risk" since it has no probability distribution and that he suggested it should be thought of as "model uncertainty". He also clarified that model risk applies both at the large, portfolio scale (e.g. choice of VAR model etc) and at the smaller, instrument level scale (i.e. pricing of derivatives).

Additionally in terms of measuring model risk then he excluded human failure from model risk measurement since in his view this was difficult to quantify - this approach did not meet with the approval of some of the audience were questioning how this could be excluded from a practical point of view. Phillip's colleague, Corinna Luedtke, then presented some work they had done on calibrating different GARCH models to observed data and showing how even a poor model could produce reasonable forecasts of risk if the time period was short. The work was interesting but again the audience highlighted that the human choice (failure?) in choosing the set of models to try was part of "model risk" and should not be excluded from the definition of model risk.

Is a model accurate? Testing the implementation of a model. Second speaker was David Chevance, Head of Equity & FX Model Validation at Dresdner Kleinwort. David outlined the different sorts of model risk: mathematical errors, missing risk factors, divergence from industry practice, model inconsistencies and implementation risk. He then outlined the sources of these risks: bugs, approximations, numerical precision, numerical boundaries and limitations on numerical methods (e.g. Sobol numbers in high dimension monte-carlo simulations).

David said a key area to start with in validating a model implementation was the front-office documentation of the product, its inputs and payoffs, its pricing model but also details of calibration methods used/needed etc. He made the point here that the documentation can sometimes specify just the deal, but sometimes can express the pricing methodology and pricing parameters. The emphasis was on completeness, accuracy and making use of all of the information available in the documentation. Obviously the ability to review the code used to implement the model was also necessary.

He discussed the trade-offs between a simple validation approach in terms of speed and efficiency of resources against the more time-consuming, resource hungry but more accurate approach of full replication of the model. He also suggested that in choosing a method of validation it was important to balance resource demands against what is actually being validated: payoffs from a single trade, a type of pricing model or a family of financial products. Desired accuracy of the validation was also important, given the trade-off between accuracy and effort, and the fact that small bugs are much more common than large.He finally discussed model version control, the necessary discipline of documenting changes and regression tests for new models, and the regular cycle of model review. Overall it was an interesting talk with a good practical focus.

Practical aspects of valuation model control process. One of the most entertaining and interesting speakers of the day was Tanguy Dehapiot, Head of Validation and Valuation, Group Risk Management at BNP Paribas. He started by referring to a few documents "Supervisory guidance for assessing banks’ financial instrument fair value practices", April 2009 (BCBS 153) which was then implemented within “Enhancement to the Basel II framework” (BCBS 157). The first part of his presentation was around these documents and what the regulators expect to be in place, so I guess the best approach is to read them (the BCBS 153 document content is only 12 pages long, quite short for a regulator!)

Tanguy pointed out that in his view "Mark to Market" and "Mark to Model" are often misleading as both are often required. He prefers the term "Valuation Methodology". He proposed four valuation modes: Direct Price Quotation, Use of Similar Instruments, Risk Replication, Expected Uncertain Cashflows (NPV) and categorised a useful hierarchy/matrix of which financial products fit into which valuation mode and for what purposes. Within model risk, he split off judgemental errors (choice of model etc) as part of market risk and credit risk and operational errors (model implementation and coding) as more definable and avoidable parts of operational risk.

He had some interesting slants on data, saying that he had been surprised that even getting all of the static data necessary to price simpler instruments like bonds had proven difficult. He outlined how model parameters are often stored across a variety of systems (curve definitions in one place, pricing methodology somewhere else) implying to me that this is sometimes difficult to pull together and needs some centralisation to improve transparency around this.

His opinion on market parameters (both observed prices and derived data such as implied volatility surfaces) were often stored in a larger central database but warned that this market parameter database needs to be reviewed as part of the model validation process since some of its data is derived (i.e. calculated, maybe using a model!) and as such should not be taken as perfect for all time and for all purposes. He said that it was important to categorise the origin of data and suggested the following types:

• Quoted on an active exchange
• Actual private transaction in an active market
• Tradable broker quotes
• Consensus prices from market makers
• Non-binding indicative prices from market makers
• Counterparty valuation, collateral valuation
• Actual transactions in inactive market

Tanguy proposed that there should a valuation matrix for each instrument, where there might a different valuation methodology used for end of day valuation verses intraday, for risk or for trading, for pricing individually or within a portfolio reval. I guess here the rational is appropriateness, efficiency and transparency about what needs to used when. He also added that he disliked the term "Model Validation" since it seemed to imply that a model was "valid" and preferred "Model Approval" to cover the decision to use a model and "Model Review" to cover model analysis. He said he found managing the "stock" of existing models (and keeping up with when to review them) more difficult than managing the "flow" of new models and products.

Overall Tanguy was a very interesting and funny speaker with lots of practical insights and a fair amount of opinion thrown in, which is always good in my view.

The usefulness of inaccurate models: Financial risk management "in the wild". This talk was given by Dr Yuval Millo of the London School of Economics and he focussed on the evolution of the use of the Black Scholes Merton (B-S-M) model at the CBOE and how the model came to be the means by which the whole options market "communicated". Yuyal is a social scientist and prefaced his talk by stating that "Social Sciences are good at predicting the past"

First thing I didn't know (amongst the many things I do not know...) is that the B-S model was not published until a couple of weeks after the CBOE started trading stock options in April1973. Yuyal said that initially the B-S-M derived prices were not accurate at all (around 25% off the market price on CBOE) and that the model was based on assumptions that plainly were not the case on the exchange (only calls available, no short selling, no continuous trading). The model was used by local Chicago trading firms and the story goes that Fischer Black sold large paper "sheets" of option pricing matrices to these traders (there being no calculators/PCs/mobiles around at the time).

As the markets developed, larger East Coast banks entered the market with stocks being held and traded in New York and options being traded in Chicago, so trading became geographically dispersed. This started the need for "early morning meetings" to discuss the market and the B-S-M model and its parameters became the "lingua franca" or means of communication of options market participants.

He described the first years of the Options Clearing Corporation (OCC) which was set up to ensure that the financial obligations of options and buyers were met. Around 1979-80 the OCC worked overnight to calculate margin requirements, based on the (now?) arcane idea that different margin amounts should be associated with different option strategies (straddles, butterflies etc) and the job of the OCC was to take a portfolio of Option and optimise which combination of strategies would minimise the margin required for the whole portfolio. He said that there were disputes between traders and the OCC around margin levels and difficulties for the SEC with updating their Net Capital Rules as each new option strategy was created. Eventually, the OCC adopted the B-S-M model and implied volatility as the means of calculating margin against market value which enabled them to move away from the operational difficulty of strategy optimisation.

So the B-S-M became the way in which traders communicated about the market but also the model became vital operationally within clearing for the market. By 1987 B-S-M had become the de-facto standard for the market, with the model driving the market in turn driving use of the model. During the Oct '87 crash the model proved to be very innaccurate but the use of the model did not diminish - maybe pschologically the market participants needed a model (even a wrong model) to make communication easier.

I found this talk very interesting and members of the audience asked whether any similar analysis was going to be done on the Gaussian Copula model used to price CDOs. Yuyal said that one of his colleagues was undertaking this research currently. Given that he seemed to be very positive about the use of the B-S-M model within options markets I asked whether he had any opinions on Taleb's criticism of fiancial engineers and modelling. Yuyal said that he and Nassim were friends and agreed to disagree on certain topics...

Stress testing modelling parameters. Next up was Peirpaolo Montana, Head of Model Validation at West LB. Having joined the finance industry out of a career in mathematics and then at a regulator, Pierpaulo began by saying that back in the heady days of 2004 the banks thought that their own risk management systems and practices were well ahead of the regulators. He said that in light of the crisis this proved not to be the case but he now feels that this is now more evenly balanced (not sure I would agree, still lots of catchin to do for some institutions I would suggest).

He said that whilst regulators require the validation of risk models and pricing models, and that stress testing of a portfolio is required, that the stress testing of a pricing model is not a requirement and has received much less attention and in his view was not done to much degree before 2007. His point here was that pricing models should work under stress too, otherwise they are a weak foundation for building other risk measures such as stressed VAR.

Whilst focussing on pricing models, he mentioned that risk models also need to be carefully chosen and appropriate to the institution and the types of trading activities it undertakes. As an example he put forward that a simple VAR calculator might be appropriate for a long only equity fund but completely innappropriate for a relative value portfolio.

He said that stress testing had recently received much more attention as a risk management tool and cited the BIS document "Revisions to the Basel II market risk framework" where stressed VAR is introduced as part of the regulatory capital charge calculation. He also mentioned that in order to avoid "standard model" treatment of complex securitised products an institution must be able to demonstrate that its VAR model can cope with these products under times of market stress.

Pierpaulo then described the stress testing of base correlation in CDO pricing, and how even moving the base correlation from its usual level of 70% to 99% would not have predicted the valuations observed in the recent crisis. In this way he says that stress testing of models can detect implementation problems and some model weaknesses, but it cannot assist in coping with structural breaks in the market. He also discussed how the B-S-M model is used everywhere (even places it should not really be valid for) since it is a robust model based on the no-arbitrage hypothesis - in contrast the CDO base correlation and other models are not so robust since they are not arbitrage free.

(end of post!)
 

 

Regulatory moves and moods

Seems that the latest EU and Basel Committee proposals on banking regulation cannot make everyone happy (now there's a surprise...). Whilst many seem very happy at the incremental nature of the proposals to increase capital requirements for securitisations and proprietary trading, some of those in the Glass-Stiegal/banking utility camp are less than impressed. I am with the incremental camp myself, but have to acknowledge that the sceptics are not short of ammunition when saying that we are heading back to the future...meanwhile over in hedge fund land, London is currently in a very bad mood with the EU...

Tick Size Harmony...

...in a rare show of co-operation (I wonder what is the carrot or (regulatory) stick here to motivate this?) European exchanges and MTFs seem to have agreed on standardising tick sizes (or at least to have two standards rather than twenty five!). Extract from article on AutomatedTrader:

"From the perspective of each trading venue, strong incentives exist to undercut others in terms of tick sizes, which is not in the interest of market efficiency or the users and end investors. This might, in turn, lead to excessively reduced tick sizes in the market. Excessively granular tick sizes in securities can have a detrimental effect to market depth (i.e. to liquidity). An excessive granularity of tick sizes could lead to significantly increased costs for the many users of each exchange throughout the value chain; and have spillover costs for the derivatives exchanges' clients."

Das's Dazzling Derivatives

Satyajit Das adds an interesting contribution the debate on OTC derivatives and the drive towards CCP in his article in the FT today (see earlier post for background). The opening paragraph sets the tone:

'US and European Union proposals for over-the-counter derivative regulations are consistent with H.L. Mencken's proposition that "there is always a well-known solution to every human problem - neat, plausible and wrong".'

Main points from the article:

• A single CCP would certainly qualify for "too big to fail"
• The success of CCP depends on collateral and collateral valuations may underestimate risk and value since these are usually based on historical volatility
• Cross-margining exposes the CCP to correlation risks in offset methodologies
• CCP depends on valuing contracts that depend upon liquid markets
• CCP margining requirements may communicate market stress to more participants and in turn create more stress
• Regulators are missing the point with CCP and should look addressing the core issue of innovation and complexity hiding excessive profits in derivatives

As a related aside, probably also worth taking a look at the following article on the return of securitisation.

Over The Counter Arguments

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

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

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

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

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

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

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

 

Risk in the Hands of the Holder?

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

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

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

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

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

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

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

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...

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).

Fight-back by the OTC Market?

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

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

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

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

High Performance Spreadsheets

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

Capital requirements for Asset Managers

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

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

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

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

Regulatory Camouflage

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

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

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

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

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

Data management, derivative analytics and the spreadsheet

Interesting article out doing the rounds on the newswires announcing a forthcoming report called "The Enterprise Spreadsheet: Pushing towards Transparency" by the analyst firm the Tabb Group. It is great to see an analyst firm acknowledging the importance of spreadsheets within the markets, particularly in the area of combining data and analytics together in OTC derivatives management (see earlier post).

Adam Sussman of the Tabb Group reckons that despite its shortcomings, Excel is a valuable tool: “Spreadsheets, either alone or in conjunction with other components, can meet the same requirements as a business application.” In this he seems to be agreeing with the UK Regulator the FSA, who have been recently advocating that spreadsheets and spreadsheet data needs actively managing as an institutional resource. The findings of the Tabb Group on management also seem to echo a recent report called "Buy-Side Data Management in a Changing Landscape" done by Lepus for Asset Control (registered link to report here).

Spreadsheets are a great tool and fulfil a real need in the market to pull together pricing models and data quickly, easily and with a timeframe that is meaningful to the business (see earlier post for some work by Xenomorph in this area). Spreadsheets are a big problem to manage, but they are also the symptom of failings in core systems that are not able to rapidly support new instrument types and pricing models. An institution that ignores analytics, spreadsheets and spreadsheet data within any EDM transparency initiative has already failed before it begins, and so to paraphrase the author Aldous Huxley:

"Spreadsheets do not cease to contain data because they are ignored."

The Respect Scenario from the FSA?

The presentation by the FSA last night on their consultative paper called "Stress and Scenario Testing (CP 08/24)" was a real disappointment last night. The presentation was at best average, not adding any more value than what you could get from scanning their paper. However, what was worse was the Q&A session at the end, with a variety of questions from the audience being answered by the FSA representative with "Thanks, that was a very good question and I will get back to you on it...".

The organisers (ISDA and PRMIA) had managed to get around 200 risk managers to attend which was an impressive turn-out with only standing room left as the event started. I would suggest if the FSA want more feedback from the industry it would be better if they would send someone along who is at least able to add value to the conversation. Their representative last night was doing his best but was just too junior, too inexperienced and lacked the confidence to answer questions in a meaningful manner.

Regulators are telling everyone to "raise the bar" on standards at the moment - they would find it helpful if they would apply this mantra to themselves and the people they put out as representing their views and expertise.

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.

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...

RiskMinds - DB on reforming the financial markets

Hugo Banziger, CRO of Deutsche Bank, gave a presentation on his ideas on how best to reform "The Global Financial Architecture".

He started by emphasing:

• The economic imperative to resolve the current crisis for the benefit of all people, not just the financial markets.
• That the current crisis is very close to the crisis of the 1930s (he did his PhD on the Great Depression, so he should probably know).
• He has been involved in the rescue of 3 banks recently, and said that one major German financial institution was only 6 days away from insolvency before it was saved.
• His opinion that letting Lehman go was a bad decision that has worsened the crisis.
• That without goverment help the financial markets would have gone into meltdown and that this state of affairs is totally unacceptable for the industry.

He proposed action in three areas:

• Monetary Policy - Governments and central banks should pay more attention to the interaction between monetary policy and global capital flows. Central bank policy should also consider targetting how to prevent asset price bubbles as well as more standard measures such as inflation (Comment: maybe my bubble index idea wasn't so stupid?). Emergency liquidity provision also needed a rethink in light of past failures.
• Regulation and Supervision - Capital requirements should be increased and capital calculations need redesigning to reduce pro-cyclical aspects so as to provision in the good times for the bad (Spanish regulator had already done this apparently). Capital calculations should be calculated over longer time periods (30 yrs?) using the worst of events from the past. Scenarios need adding into the capital calculations so they are not just probabilistic in nature. Regulators should insist upon better transparency and disclosure, in particular on valuation methods and the methods of the Credit Rating Agencies. Ultimately, regulation needs be co-ordinated on a global basis given the global nature of the markets.
• Private Insitutions (the Banks) - Appalled by the lack of integrated risk management at many banks, and clear governence of the risk is essential. IT systems should be robust and centralised access to data to calculate exposure is essential. A typical cost of $200m to implement Basel II indicates to him that basic technology infrastructure is not in place and good risk management cannot be being done. Having data in spreadsheets and reporting to regulators with a 3 month timeframe is not good enough and the industry needs to get the infrastructure in place to properly handle and report in a timely manner upon the risks it is taking. He proposes that each bank needs to get a diversified and stable funding base in place - DB issued long term funding recently to reduce dependence on short-term sources and has $65b in reserves, so (maybe at the risk of sounding smug) he believes DB is well positioned.

Interesting talk, Hugo risked coming across as a little smug in the presentation but did admit that DB had faced problems too (but just not as bad as most other institutions though!).

 

 

RiskMinds - insurers on the crisis, risk managers (and suicides...)

Panel debate amongst CROs from some of the big insurers and the FSA. Main points:

• Summarised the current crisis as "A collective failure of imagination over the scenarios of what is possible by risk managers and regulators"
• Insurers are doing better than the banks in the current crisis, and this is due to learning from the bad experience insurers had in 2002 following the collapse of the dot com bubble.
• Quants are not to blame for the current crisis - they are involved but the current liquidity crisis is not a quant issue (Comment: but surely the collapse in asset prices from poor modelling is what led to the collapse in confidence and onwards to the liquidity crisis)

Joachim Oeschlin, CRO of Munich Re said that at a recent panel event he asked a group of risk managers what had been the failings of risk management, was it:

• Risk managers enjoyed the credit party like everyone else?

• Risk managers did not see the bubble coming?

• Risk managers did not have enough power?

The response from the risk managers was the latter (unsurprisingly!) but he favours the first two explanations above. Joachim said that Munich Re had been looking at how their company performed in the Great Depression of the 1930s. It seems that we should be thankful that we have personal bankruptcy laws these days, as one thing he noted was a great increase in suicides in the 1930s as people who owed too much money simply killed themselves...maybe we haven't got it so bad after all. Crisis? What crisis?