30
April 2011
Journal of Applied IT and Investment Management
SimCorp
# Challenges in the front office: new regulations
force derivatives market overhaul
Evident during the recent financial crisis, and in the context of current regulatory reform, is the high level of systemic risk that exists as a by-product of the use of over-the-counter (OTC) derivatives. This article assesses the front-office tools needed to effectively manage their use, and previews the potential effects of changes in market structure on the IT demands of the front office.
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Brent Rossum is Domain Manager, North America Front Office, SimCorp NA.
hile much maligned given their role during the crisis, OTC derivatives, when used properly, will continue to be powerful tools to manage investment risks and structure portfolio strategy. While OTC derivatives did not cause the crisis, the inter-connected financial obligations between organisations due to their use did cause a near financial system meltdown. The Dodd-Frank Act, signed into US law in 2010, covers many aspects of financial reform, but has a clear goal of reducing, or at least controlling, the amount of systemic risk in modern markets. By June 2011, US agencies affected by the legislation, notably the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) but also in concert with international agencies such as the UK’s Financial Services Authority (FSA), must add substance by putting into place rules and structure to underpin the legislation.
tion risks brought to light since 2006. While the effects on the sell-side are more drastic, the buy-side can expect more direct changes as Swap Execution Facilities (SEFs) and Central Counter Parties (CCPs) come on line. The goal of reducing systemic risk may be clear, but the timing of these changes is not. This creates an ongoing challenge not only for market participants but also for those who manage the IT systems that participants will use as the market adopts new styles of trading and absorbs new reporting requirements. Another key challenge for IT managers in 2011 comes from the continued use of OTC derivatives by the front office during the transition to a new market structure and as the goal of a stable, robust and liquid market is realised. To use OTC derivatives appropriately now and in the future, the front office needs tools that offer a clear understanding of exposure to risk, leverage, and counterparties, given the complexity and inter-connected nature of the modern financial markets.
“An increased focus on risks, and lessons learned, will lead to a push for IT to provide tools that allow for a greater understanding of current risks.” Most of the efforts made by global regulators are meant to instil confidence in the system and boost transparency and liquidity. Many reforms try to reduce the opacity of sell-side trading operations and mitigate counterparty concentra-
Key items to address in 2011 for those who manage IT platforms that support frontoffice OTC derivative operations are: • Transparency and control over ap-
plications that describe exposure,
provide valuation and calculate risk;
• Flexibilit y in on-boarding new
workflows into existing front-office applications.
EXPOSURE TOOLBOX OTC derivatives are indeed complex, both in their structure and in their impact on the investment portfolio. The basic assessment to make is: does the front office have all the tools necessary to determine their various exposures to risk? Does the front office use disparate platforms to manage investments leading to an inability to holistically review risks? An increased focus on risks, and lessons learned, will lead to a push for IT to provide tools that allow for a greater understanding of current risks. The old standards sought to measure weights in classifications such as currency, credit ratings and issuer exposure. With the increased complexity of the markets, that definition must extend to include counterparty and leverage, but also measures that capture non-linear returns and specific risk-exposure characteristics of certain security types. Counterparty exposure Counterparty exposure is not as simple as keeping track of those with whom you trade. Any OTC transaction will involve counterparty risk, as the potential payment of profits will directly involve their ability to pay, or even, as after the bankruptcy of Lehman Brothers, to retrieve pledged collateral against trading activity. Before the crisis, counterparty exposure analysis aggregated all exposures due to trading activity, performed stress tests on likely profits expected, then assessed if any party was overexposed. The