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Articles Archive
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September 2003
Bridging The Trading Lifecycle With Integrated Risk Management Software
JEAN-CLAUDE RISS, managing director, OpenLink International looks at how integrated risk management software can take the risk out of the trading lifecycle.
Over the past 20 years, global businesses have developed a sophisticated array of concepts and tools to manage risk. They have applied a somewhat uniform framework to estimate extreme conditions, using techniques such as Value at Risk (VaR), the Risk Adjusted Return on Capital (RAROC), Monte Carlo simulations, the Greek alphabet of option theory, and an array of statistical tools.
Now, managing global risk requires a more dynamic approach. Active risk management uses a combination of qualitative as well as quantitative approaches, including sophisticated tools to evaluate a trade at the event, position, and portfolio level. Trading in today's volatile markets requires a highly integrated risk management structure that not only measures and values the risks of the completed deals, but also evaluates the likely effect of pending transactions. Such concerns no longer are the exclusive responsibility of risk managers. Now the front, middle and back offices are increasingly linked in a chain of risk analysis, covering market, credit, and operational exposure.
A few years ago financial markets were distinctly regional, and were only peripherally impacted by price and economic changes in other markets. The rapid growth of information technologies has enabled trading enterprises to reach across the globe, providing unprecedented levels of data aggregation and integration. The result has been the delivery of a single, consolidated view of an enterprise's global business, market exposures, and counterparty risks.
In retrospect, the globalization of information created numerous arbitrage opportunities. Initially, the opportunities were in the foreign exchange and the dollar funding markets as market traders sought the best price and greatest liquidity. Later, the banks' regional position risk in spot dlr/yen and spot dlr/dem became worldwide books with a commensurate exposure to global prices and economic changes. This sparked the development of new financial instruments, futures, FRAs, and swaps. It also accelerated the trend, as banks realized the profit potential of the linked domestic and international markets.
But most banks were slow to realize the accumulating risks and continued to manage their exposures to counterparty and market risk at the local level. The stock market crash of October 1987 changed that method of operation. The London market had been closed on a Friday due to bad weather and the Asian and European markets were unable to clear business. The backlog of orders created a tidal wave of selling pressure on the following Monday which, along with programmed trading in the futures markets, melted down the price and liquidity mechanisms of the markets.
New capital control methods
It was apparent that widely accepted risk management practices were insufficient to recognize or control the global exposures that banks and other financial institutions were holding - particularly in the `off-balance sheet' derivatives markets. This led to the reassessment and revision of the controls under the original Basel accords for capital adequacy.
Among the control methods adopted was VaR, developed by JPMorgan as a framework for consolidating exposure risk in different asset classes into a single dimension of capital risk. Other techniques like RAROC also began to be applied across the global activities of treasuries. Central banks and regulatory authorities adopted these techniques, and others, to provide greater transparency and an improved measurement of the global risks seen daily in the international banking business. This marked the emergence of risk management from the accounting department into a separate corporate activity.
Now, global position data in near time is a commonplace requirement. VaR analyses using Monte Carlo methodologies, cross-asset, and crossmarket evaluations - together with increasing complex correlation matrices - are routine, as is the ability to perform ad-hoc inquiries into the bank's global exposures to markets and counterparties.
But despite the implementation of increasingly sophisticated risk management tools, the markets have continued to push the edge of the envelope.
By increasing liquidity and price transparency across many different classes of assets, information networks have commoditized many markets to the point that revenue and profit can only be realized through greater volumes of business with more counterparties, increasing exposure to both market and credit risks.
To optimize their business, banks have turned to even more complex instruments that can only be managed with more sophisticated analytical tools.
Three step process
In the customary structure of a bank treasury, the trade lifecycle is expressed as a sequence of events that pass through the front, middle and back office processes.
In the front office, employees evaluate a trade's potential, the associated market risk and its counterparty risk. Traders also consider the value added to their open positions held, and the likely profit and loss impact. They are not concerned with the capital impact of the trade, except where expressed through available trading limits.
In the middle office, the risk managers evaluate the effects of the aggregate trades booked within the firm's portfolios and the global positions held. VaR, RAROC, and other tools are used to perform these evaluations and, except to set trading limits, are post-event.
The back office operations staff processes the trade. Their principal concern is that the settlement of the trade is completed. However, as the complexity of trades has increased, so has the likelihood that trades might fail to settle.
These three operations are the subsets of the trade lifecycle. Viewing this workflow as a continuous process, straight-through-processing (STP) software has been developed to streamline and join these functions. STP can eliminate redundancies, significantly reduce operational overhead, and improve profitability. But the automation and linking of the transaction trade capture and confirmation processes has lowered an often overlooked and significant cost within this workflow, the 'cost of fails'.
New technology platforms develop
Changes in the markets and the resulting increase in the complexity of risk management have driven the demand for technology platforms that support the realtime analysis of this workflow process. Analysis of complex trades has brought risk analysis and risk management into the front office. The VaR effect of these trades and the risk impact across multiple asset classes requires that the types of evaluation, that formerly were post-event procedures, be performed pre-event with the front office assessing the 'fit' of the trade. This has brought the middle and front office together in a single risk environment that demands dynamic market and credit risk evaluation.
Also, front office processes have been integrated with back office processes through STP mechanisms, refined to straight through exception processing (SteP), which uses tests and filters to automate the 'four-eyes' principle of back office workflow control.
The third, and most recent, change is the advent of the Basel II Operational Risk accord. This regulatory requirement will impact the operations of a bank's back office to a major degree. Despite well-documented problems associated with the cost of fails, some banks continue to treat this as an issue of internal efficiency and bottom line profitability. Basel II will alter that perception at its roots because the cost of fails will no longer simply be an earnings issue. It will become a capital expenditure that impacts the balance sheet, as regulators require banks to reserve capital against these events.
The effect of Basel II will be to marry the risk management function with process management, in other words, the middle office with back office. The front and middle offices are already connected due to the requirements for complex and rigorous analysis of the value of a trade before the event. The front and back offices are connected through the mechanisms of STP and SteP, where a failed trade will be returned to the front office for correction. The middle and back offices are now connected through the capital requirements against operations set out in the Basel II accord.
Thus the management of the lifecycle of a trade has become completely interactive. Risk management has changed from a passive evaluation of trading and processing risk into an active measurement of the entire risk cycle. The process requires sophisticated software that is full integrated across the entire trade life cycle, providing support and analysis at the trade event level as well as at the position and portfolio level.
Banks have never had a greater incentive to ensure that their processing systems and procedures provide this level of risk measurement and management. Apart from good corporate practice, the Basel II Accord will impose operational risk capital charges that will penalize those organizations failing to implement stringent qualitative, as well as quantitative, measures to reduce the costs of trade settlement failures.
Jean-Claude Riss is the managing director of London-based OpenLink International, the European arm of OpenLink.
As seen in Informa's Back Office Focus newsletter - September 2003
Copyright © 2003 Informa UK Ltd. All rights reserved.
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