The Risk Analytics Library: Time for a Single Source of Truth

The Risk Analytics Library: Time for a Single Source of Truth

As the tail of post-Global Financial Crisis (GFC) reverberations stretches further into the future,

the magnitude of regulation-induced impacts on the largest banks and asset managers continues

to be unclear and largely unquantifiable. Despite this uncertainty, one thing is certain: Sins of the

past are rising to the surface, and two in particular are cause for a major rethink of the best -

practice approach to effective risk management and the necessity for supporting platform

architecture that achieves much more timely, accurate and comprehensive risk measurement.

First, credit risk is currently upstaging market risk as the priority focal point for risk

measurement. It needs to become a core and enterprise-wide competency. However, since the

practice of credit valuation adjustment (CVA) is mainly found in the pricing of OTC derivatives,

such an enterprise functionality rarely is found in most firms, particularly on the buy side. This

needs to change, and fast. Second, though an unintended sin, tolerance of technical

fragmentation over the years has led to far too much complexity and far too many versions of

output. This also needs to change as fast as an organization can move.

The sooner folks can sing from the same song sheet when it comes to a unified view of risk, the

better off individual firms and the broader financial ecosystem will be. TABB Group believes that

an effective component of the platform used to satisfy these critical needs is a central, multi-

asset library of risk analytics from which everyone in a firm can draw.

E. Paul Rowady, Jr.

V11:015

April 2013

www.tabbgroup.com

The Risk Analytics Library: Time for a Single Source of Truth | April 2013

2013 The TABB Group, LLC. A ll Rights Reserved. May not be reproduced by any means without express permission. | 1

Exhibit 1:

Risk System Spending – A Rare Bright Spot

Source: TABB Group

Introduction

Having reached its apex around 2007, the capital markets’ pendulum is swinging back,

changing course and retracing its arc of the past three decades. The following chain of

events, which began with the GFC, and which is being perpetuated by the mass and

unprecedented regulatory (and interventionist) response to this crisis, will continue to see

challenges to business growth, continued resource constraints in nearly all corners, and,

ultimately, major shifts and reconfigurations in capital markets business models. In turn,

these shifts will require new technology strategies where capabilities are right-sized for new

regulation-induced transparency and competitive requirements and costs are right-sized to

the new scale and profit expectations of opportunities.

Do not be fooled by strength in stock markets, because they are not indicative of the

magnitude and permanence of the underlying shifts in the broader capital markets

landscape. Across all asset classes, market structure, trading costs and demographics are

collectively in the process of unprecedented transformation. As this transformation

continues, unintended sins of the past will keep showing up like reefs in a receding tide at

the precise moment that the market ecosystem can least afford it.

Meanwhile, the performance requirements for enterprise data management (EDM), coupled

with a much broader spectrum of risk-related analytics (extensively covering market, credit ,

liquidity and operational risks), have never been greater. How to do much more with far

less is going to remain a mantra for the

foreseeable future. Data- and risk-related

upgrades will determine the survivors. As a

result, there will be ongoing “budgetary air

cover” for such improvements that can be

justified under the guise of regulatory and

compliance initiatives. For now, ongoing

investments in risk analytics and underlying

data management functionality continue to

grow, bucking the trend of resource constraints

in all other corners of the organization. TABB

Group estimates that of the top 15 sell-side IT

spending categories, only pricing/reference

data and risk management are areas of

expected growth in spending for 2013 (see

Exhibit 1). Furthermore, TABB Group believes

that this general trend is likely to persist over

the course of the next 3-5 years. Moreover, for the buy side, the outlook is even more

pronounced, since buy-side firms have historically lagged the sell side in their proportion of

IT spend on risk analytics solutions. If the gap between the buy side and sell side widens

even further, the disparity between the two will become a risk of its own.

Lastly, TABB Group believes that risk and data-related spending needs to be targeted at

overcoming past flaws in risk measurement strategy, which can generally be described as



Exhibit 2:

OTCD Rates - Clearing Segmentation Estimates

(February 8, 2013)

Source: TABB Group, DTCC, BIS

Estimate of notional outstanding in current OTCD Rates

“clearability” segments

ExoticsSemi -Exotics

<<<< OTCDs >>>>

Clearly Unclearable

Potentially Clearable

<<<<<<<< Vanillas >>>>>>>>

<<<< Cleared >>>>

Global Risk Transfer Market (GRTM) - Product Spectrum

29.3%

??

No Hedge

<<<< ETDs >>>>

12.2%58.5%

Battlegrounds

HybridsFuturesOptions

Cash

? ?

Available for Clearing

capability gaps and complexity costs. For capability gaps, credit and liquidity risk analytics

stand out as an area that has remained significantly underdeveloped from an enterprise

point of view. For complexity costs, technical fragmentation and other impediments to the

creation of unified and enterprise views for risk also need focused attention.

The Golden Age of Credit Risk

Many close observers of the OTC derivatives (OTCDs) markets during the post -GFC era have

been operating under the assumption that, with all exposures presumed to be going to

central clearing – and remaining bilateral exposures eventually dying on the vine due to

higher costs – the importance of topics such as CVAs would wane significantly. After all,

many of those who sit on so-called CVA desks at major dealing banks have recently

commented that the vast majority of their activity – something on the order of 85% – is

related to pricing of bilateral, non-cleared OTCDs.

Upon closer analysis, it turns out that CVA is not going to wane in importance for a long

time. In fact, in the four-legged risk stool – where the legs are broadly represented by

market, credit, liquidity and operational risks – credit risk has made a resounding move to

center stage over the past 2 years. Fast approaching milestones within the global

regulatory transformation are the primary driver of this focus on counterparty credit risk.

TABB Group recently estimated that 55% of the approximately $670 trillion in global

notional value in OTCDs (as of February 2013) are being cleared (across all asset classes),

with 5% categorized as “clearly unclearable” and the remaining exposures – some 40% –

designated as “potentially clearable”. With currently cleared structures limited to only

vanilla swaps (i.e., fixed-vs.-floating), basis swaps, overnight index swaps (OIS), and

forward rate agreements (FRAs), the uncleared components consist of a mix of trade

structures that include one or more of the

following core attributes: client-side (or

“D2C”), non-linear, illiquid currencies, and/or

otherwise exotic.

Using trade repository data specifically for

interest rates derivatives from the Depository

Trust and Clearing Corporation (DTCC) as of

February 8, 2013, TABB Group is able to

enhance its estimates, as follows: 58.5% (of

OTCD rates exposures) are cleared, 29.3% are

available to be cleared (i.e., mainly client-to-

dealer, or D2C); and the remaining 12.2% are

potentially clearable or clearly unclearable, in

both dealer-to-dealer (D2D) and D2C

categories (see Exhibit 2).



Exhibit 3

Persistence of Exotics

Source: TABB Group, DTCC

The objective of a more detailed estimate and segmentation of exposures is to illustrate just

how the remaining 12.2% – or, a very large $65.8 trillion – is set to remain on the books of

systemically important financial intermediaries (SIFIs) for the foreseeable future (see

Exhibit 3).

Here is the bottom line for this part of the analysis: Unless these exposures are novated or

otherwise terminated – and without making any assumptions or assertions about the

creation of new unclearable trades – at least some tens of trillions of dollars of notional

values will remain in the system for two decades. For instance, nearly $6 trillion of mainly

swaption exposures have durations of 30 years or more. As a result, each counterparty in

the vast tapestry of nearly $66 trillion in unclearable exposures will need – and in most

cases, be required – to implement the ability to assess the risks associated with these

positions for years to come. In short, one could argue that credit risk and pricing factors

such as CVA have never been more important than they are right now.

But the CVA story doesn’t stop there. Credit value adjustments have the potential to be

embedded into the pricing of all counterparty relationships going forward, such as prime

brokerage and financings for hedge funds, or concentration of exposures with all kinds of

counterparties, such as CCPs. Moreover, there is little or no parallel to this story on the buy

side, where there has traditionally been no need to “price” the counterparty risk in anything

other than holdings in stocks or bonds. Now the pricing of counterparty risk is everywhere,

in all types of transactions.



At the end of the day, it turns out that the skeptics of CVA couldn’t have been more wrong.

Clearing doesn’t even matter in the context of reducing bilateral exposures. In an

increasingly resource-constrained – and deleveraging – environment, embedding the price

of counterparty credit risk into all transactions has never been more important. In many

ways, we are entering a golden age of credit risk analysis and not the other way around.

For those that have been actively engaged in the swaps markets, the importance of credit

risk and CVA is nothing new. The fact that it has become so mainstream, however, is quite

new – it is now on both sides of the proverbial Street.

Now add the impact of liquidity analysis on the calculation of margin requirements and

consider that much of the capability to perform these tasks is not even in place today. For

instance, in a study conducted by the EDM Council in 2011, 60% of data management

program drivers were related to risk, compliance and regulations; however, only a small

percentage of expected functionality – as low as 8% for leverage and funding risk – had

been implemented at that time (for large and medium-size players), leaving significant work

yet to be done.

TABB Group estimates that there are 350-400 large financial intermediaries, including

dealing banks, super-regional banks, asset managers, and hedge funds, as well as a few

utility players (such as CCPs), that make up the vast majority of exposures in the global

capital markets. It is this community of participants that is the most intensely focused on

credit, counterparty and liquidity-related risks. And although these concerns and needs

certainly penetrate further into the spectrum of mid-size and smaller players, it is the

largest and most complex firms that can benefit most from an enterprise risk analytics

library.

Complexity of Technical Fragmentation

Technical fragmentation represents another significant source of impediments to enterprise

visibility and timeliness of risk analytics. As a result, streamlining, consolidating and

thoughtfully centralizing risk measurement capabilities is of critic al importance to right-size

costs and performance requirements for the road ahead.

There are three sources of technical complexity that central libraries can help solve. These

include:

1) Elastic Fragmentation: Cultural tolerance for and/or policies that allow broad latitude

for solution choices – even for the same or similar purposes.

2) Legacy Fragmentation: Accumulation of similar solutions – or versions of solutions,

some of which are tied to outdated technology, old rules and former clients – over a

long period of time.

3) Transactional Fragmentation: Accumulation of redundant solutions and functionality

as a result of mergers, acquisitions and other business combinations.



Large sell-side firms are most likely to suffer from each of these forms of technical

complexity, as well as the second-order complexities caused by the combinations and

permutations of these. On the buy side, the transactional and legacy fragmentation

complexities are less prevalent, with the exception of the largest and most established

players.

In both cases, elastic fragmentation has been the result of nearly three decades of

consistent market development, financial product innovation and high profitability. These

were among the most consistent excuses for technological “elasticity” and fragmentation.

For the sake of expediency (and due to the lack of standards), maximum flexibility in the

choices of systems and architectures was tolerated. In many ways, internal competition

was promoted and supported to weed the garden of mediocre performers. With internal

competition came the latitude to choose, if not for any other reason than each performer

(each desk or business unit) was granted protection of its special sauce with high degrees of

latitude to choose a toolkit. The front office was the poster child for this phenomenon.

Going forward, commitment to the benefits of internal competition will need to be limited to

the use of tools and not the choice of tools.

Overall, the complexity of technical fragmentation is a lose-lose situation in the short term.

It takes a lot of effort to maintain it, and it takes a lot of effort to change it. However, the

upside to changing it – and changing it with an eye toward future proofing – is that

performance and “operational alpha” are enhanced. Maintaining complexity becomes more

expensive as the utility of the underlying framework decays. Since current monolithic

architectures have proven ineffective and cumbersome in achieving the new risk and

reporting performance requirements, market forces are highlighting that a new approach is

desperately needed. We are at the tipping point of technical innovation in the development

of centralized, enterprise risk analytics libraries.

Digital Libraries

Raw computational functionality is not the primary impediment to meeting the requirements

of the new regulatory regime. The challenge is the massive integration of systems and

aggregation of data necessary to foster “data fluency”. Most of the 350-400 largest

financial institutions need to simultaneously consolidate numerous legacy systems and

move post-trade data to the front office for enhanced pre-trade decision support (see

Exhibit 4, next page).

Otherwise, they have no chance to accomplish the functionality objectives for credit

analysis, collateral management and capital controls in the required timeframe. The

backbone of all of these metrics is the same or similar. There is a significant data challenge

– hence the focus on integration and aggregation.

Suddenly, firms need to consolidate positions across dozens or hundreds of desks across the

enterprise (which often spans the globe) and harmonize the metrics. Firms need to bring in

data from multiple internal sources: legal, collateral, credit risk and liquidity models. Only

then can simulations, stress tests and other “what-if” scenarios can be run with confidence.



And then the output from these analyses need to be harmonized and managed. This is all a

huge – but necessary – shift that can be dramatically simplified, in part, by creating a

central store for analytics (see Exhibit 4).

And though it is yet to become a ubiquitous requirement today, speed of computation of

risk sensitivities will enter the equation on the back of many of the regulatory mandates –

which means very soon. Today, some firms are measuring risk only once per week – which,

if you are an active hedging firm, borders on negligence. Once-per-week to daily to

intraday to real time is a huge series of leaps, with massive architectural implications.

Although there are techniques to cut corners by calculating some inputs at lower

frequencies, this is still a monumental industry-wide aggregation project. Getting hundreds,

if not thousands, of systems to speak to one another is unprecedented. Most systems won’t

make the cut, and because of this, some of the larger firms won’t make the cut either.

Taking the hard road toward simplification and unification sooner rather than later will pay

big dividends.

Lastly, a central library of analytics does not suggest that an individual or business unit will

lose its ability to customize its views of risk. Though internal competition (which allows for

greater latitude in choosing solutions) definitely needs to be reduced in the new paradigm,

we are not here to suggest that everyone at the same shop adopt the same modeling of

risk. Consistent firm-wide views of risk metrics is the goal. Having them – with an option

to customize – is a much more sound practice than not having them and pretending

otherwise.

Exhibits 4 and 5

Shifting Toward Centralized Libraries

Source: TABB Group



Conclusion

In a former chapter of capital markets history, maximum flexibility was (believed to be)

needed at the desk level due to the rapid, on-the-fly nature of product innovation.

However, the unintentional sins of this approach are now coming loose from their cement

shoes, floating to the surface, and requiring critical attention at precisely the time when

resources are becoming increasingly scarce. Capability gaps and complexity costs can no

longer be ignored or papered over.

As a result, the most complex capital markets firms are typically among the first to

acknowledge the need for a series of more centralized stores of enterprise intelligence, or

libraries. As product, process and other standards proliferate and become more mature, the

barriers to creating such centralized libraries are dramatically reduced. TABB Group

believes that some of the best examples of these might include a meta-data library (a

source from which all “primitive,” organizational data is categorized); a project, task or

functionality library (a source from which all application or applet functionality is stored and

catalogued); and an analytics library (a source from which all risk calculations can be

organized).

Moreover, the cloud/app architecture forces a rethink of enterprise risk architecture around

an integrated analytic platform – a platform that includes the cross-asset library but also

the compute and memory scalability, rapid application development (RAD) tools, primitives

for securities data, counterparty data, credit support annex (CSA) information, and real-

time business intelligence/visualization functionality. Ignoring the need to rethink business

models and right-sizing technical architecture (in part, through consolidation, simplification

and centralization) is tantamount to sticking one’s head in the sand.

Yes, market transformation can be painful. Ultimately, some business units may need to be

jettisoned, others forced into protective custody with other business units, and still others

that will be dramatically overhauled – receiving deep makeovers – and all of the above will

need to be done much more efficiently in terms of resource allocations, time and personnel.

Yesterday’s “should-haves” are now becoming today’s “must-haves.”

At the base of it, risk is simply the absence of certainty: Know an outcome in advance, no

risk. However, the simplicity ends right there in the words. There really never is any

certainty – as much as we might like to pretend otherwise from time to time. The best

consolation prize for a persistent absence of certainty can be only the pursuit of ever-

improved clarity. However, technical fragmentation, layers of complexity, and asymmetric

clarity are not a sufficient proxy for full enterprise clarity. In fact, TABB Group believes that

timely enterprise clarity with less accuracy trumps isolated and episodic clarity with higher

accuracy every time – because it’s always the stuff in the dark that gets you in trouble.

The days of each desk or group picking its own systems and vendors are over. In order to

develop a unified view of risk throughout the organization, an integrated platform with a

centralized multi-asset risk analytics library will need to be put in place. Whether folks

realize this, and how to accomplish such a huge task, is no longer a story for another day.

The time for a resurgence of libraries is precisely right now.



About

TABB Group

TABB Group is a financial markets research and strategic advisory firm focused exclusively

on capital markets. Founded in 2003 and based on the methodology of first-person

knowledge, TABB Group analyzes and quantifies the investing value chain, from the

fiduciary and investment manager, to the broker, exchange, and custodian. Our goal is to

help senior business leaders gain a truer understanding of financial markets issues and

trends so they can grow their businesses. TABB Group members are regularly cited in the

press and speak at industry conferences. For more information about TABB Group, visit

www.tabbgroup.com.

The Author

E. Paul Rowady, Jr.

E. Paul Rowady Jr., a senior analyst at TABB Group since early 2009, has more than 22

years of capital markets, proprietary trading and hedge fund experience, with a background

in strategy research, risk management and technology development. He also has specific

expertise in derivatives, highly automated trading systems, and enterprise data

management initiatives. Rowady earned a Master of Management from the J. L. Kellogg

Graduate School of Management at Northwestern University and a B.S. in Business

Administration from Valparaiso University. At TABB, Mr. Rowady has authored “Many

Shades of Vanilla: The Increasing Complexity of Hedging”; “The New Global Risk Transfer

Market: Transformation and the Status Quo”; “Reference Data Management: The Key to

Operational Efficiencies”; “Real-Time Market Data: Circus of the Absurd”; “An Agency

Brokerage Model for Swaps: Evolution of Liquidity Access”; “Initial Margin for OTC

Derivatives: The Burden of Opportunity Costs”; “Quantitative Research: The World After

High-Speed Saturation”; “Interest Rate Derivatives 2011: Collateral Damage in the Duration

Market”; “The Global Risk Transfer Market: Developments in OTC and Exchange-Traded

Derivatives”; “Trading in Asian Derivatives: Opportunities Near and Far”; “Global Markets on

Demand: Unified Infrastructure Required”; “OTC Interest Rate Swaps and Beyond: The Path

to Electronic Markets” and “US Futures Markets: In the Crosshairs of the Algorithmic

Revolution.” He also has co-authored “(Hedge) Fund Administration: The Selection Criteria

for a New Market Reality”; “The Investment Assembly Line: Alpha Discovery and the Illusion

of Automation” and “Risk Analysis On-the-Fly: Fast Markets, Complex Portfolios.”

http://www.tabbgroup.com/



www.tabbgroup.com

New York

+ 1.646.722.7800

Westborough, MA

+ 1.508.836.2031

London

+ 44 (0) 203 207 9397

http://www.tabbgroup.com/

The Risk Analytics Library: Time for a Single Source of Truth

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