Counter(party) Intuitive

| FinReg

By Steven Strange, Fidessa

Originally published on TABB Forum

Pressures from all sides are driving buy-side firms around the world to pay ever-closer attention to counterparty exposure. Asset managers are looking critically at their existing processes for monitoring and controlling counterparty risk and often finding them to be inadequate. How has the counterparty landscape changed for the buy side, and what can be done to ease the burden?

No longer enough

Once upon a time, a good credit rating was sufficient to establish a counterparty’s fitness as a trading partner. Counterparties were managed via simple “do not trade” lists delivered to traders at the start of the day, and traders honored these by hand, or by using basic software and home-grown tools.

Times, of course, have changed drastically. Regulators now expect firms to aggregate their counterparty exposure across asset classes and include a myriad of additional holdings where the counterparty is in any way affiliated. “Do not trade” lists are monitored far more closely and updated swiftly as conditions change.

Clients are more demanding, too, as everyone attempts to mitigate risk in an ever-nervous market. Having become used to the accuracy and speed of automated reporting, they are no longer satisfied with manually generated reports based on post-trade transactional data. Institutional clients are also more likely to have counterparty risk guidelines in place, which must be navigated individually – a task that quickly becomes complex when multiple clients are involved.

Current systems don’t measure up

Most OMSs and internal systems simply aren't up to the job. Aggregating risk is much more difficult now, when a given counterparty could be any (or all) of: an issuer for a security within the fund; an indirect issuer for a security within an index or ETF; or a counterparty to another trade in a different system. Or a counterparty could cause a knock-on effect if it were to fail and impact affiliated entities.

Calculating total exposures is even more complicated. Outstanding options orders might use mark-to-market or delta-adjusted values, where interest rate swaps use notional. Working out the total exposure from outstanding orders in each asset class, considering both hedging and netting arrangements, and then rolling them up into a single value, is either beyond the capability of most systems, or too time-consuming to be feasible on a pre-trade basis.

Compliance and risk managers are at the coalface of this new battle to conquer counterparty complexity. “Do not trade” lists have broadened to become “do not trade with broker X for asset Y, but asset Z is ok.” Some firms take this a step further, setting different limits by broker for FX spot, FWDs and swaps. Lists must be updated many times a day as market conditions and trading activity change exposures in real time. Restrictions can even be hierarchical, where higher-order restrictions supersede more granular restrictions on brokers or assets, even when those lower-order restrictions haven’t been breached.

A patchwork solution

At some firms, daily limits are still supplied manually in the morning. Throughout the day, each trade must be manually calculated and deducted from the limit. Elsewhere, the end-of-day operations team extract trading data from multiple trading systems into a different database, run a series of queries to test adherence to trading mandates, and then send the results to the risk team to be managed.

This broadening and deepening of complex manual systems is clearly unsustainable. Fragmented processes and systems across regions, asset classes and acquired firms add even more layers, all of which is an anathema to achieving the control that firms – and regulators – want, and clients demand.

It’s an additional source of frustration for risk and compliance managers that a fundamental requirement for controlling and monitoring trading activity – i.e., the trading data itself – is located only within the trading system. The middle office often doesn’t have adequate access to trading data and receives notice of violations only after the fact, with no supporting data, from systems over which they have no control.

Better alternatives exist

There are some levers that forward-thinking asset managers have begun to pull that protect the firm and its clients, and ease burdens for the back office.

First, decision-making authority has been transitioned from trading operations to a compliance or risk management group.  This independent perspective gives senior management an independent and holistic view of counterparty exposure and removes that burden from traders.

Second, a single point of implementation and monitoring is chosen and supported by removing manual processes in favour of automation. The cost benefits of doing this are backed up by significant improvements to recall and auditability. Additional benefits include the ability to implement controls proactively, and to respond quickly to changing conditions.

Obviously, the solution requires technology. In assessing the available options, firms should closely look at the counterparty assessment capabilities of a system, which should provide the flexibility to add and alter rules, lists and calculations during business hours. Risk calculations should be sophisticated and aggregate overall counterparty exposure using all the different metrics based on asset class, and include related holdings issued by the counterparty.

Any system will need to integrate seamlessly with the order management systems in use in the front office, and provide transactional data to the middle office for monitoring and control.  It must account in real time for the impacts of trade amendments on exposures as well.

In this way, breaches of counterparty risk limits can be prevented before they occur, and burdens are lifted from trading, risk, compliance and administrative staff. Forward-thinking asset managers are becoming “counterparty intuitive” to everybody’s benefit. And this means that they not only run better operations, but also position themselves to win more business and maintain their competitive edge.

Tags: FinReg, Blog , Regulation