Whitepaper CCP R0710 v2

8/8/2019 Whitepaper CCP R0710 v2

1/12

Emerging rom the fnancial crisis:

A new era or CCP risk managementJuly 2010


2/12

Contents

Foreward ......................................................................................1

Risk management lessons learnt ..................................................2

Enhanced role for CCPs in achieving market

efciency and stability ...................................................................3

Laying the foundations for growth .................................................5

Key characteristics of an effective risk

management technology solution .................................................6

Conclusion ...................................................................................9

Emerging from the nancial crisis: A new era for CCP risk management


3/12

Dear Colleague,

The recent disruptions to global nancial markets and the resultant economic downturn have underscored

the vital role of risk management in avoiding systemic market failures. While there are signs of a cultural

shift in the way organisations perceive risk and a growing recognition that risk is no longer the concern of

just the chief risk ofcer and in fact needs to be managed holistically across the organisation, much work

remains to be done. A risk culture needs to be established at board level and embedded throughout

the organisation and its operations with the appropriate specication of risk appetite, forecasting

methodologies, information technology, infrastructure, reporting and processes.

As the global nancial community and regulators seek to implement solutions to prevent future market

dislocations, a unique window of opportunity has been opened for central counterparty (CCP) clearing

organisations. CCPs are being propelled onto the world stage because of the unique role they can play in

signicantly reducing risk and enhancing market efciency and stability.

Proposals by international policy makers to mandate CCP clearing for over-the-counter (OTC) derivatives

have created growth opportunities for CCPs to increase volumes, as well as expand their product range

and geographical reach. The regulatory proposals intend to capitalise on a CCPs ability to provide

improved transparency, centralised collateral management and increased nancial transaction efciencies,

with the ultimate objective to minimise and manage counterparty risk, and reduce systemic risk in global

nancial markets.

For CCPs that are planning to pursue growth, it is now more critical than ever to examine how risk ismeasured and managed across their organisations. This will enable them to determine what technological

and operational infrastructure changes are needed in order to support business expansion.

This paper will identify a number of characteristics for an effective risk management technology solution

that will provide a platform for growth. From our experience, the most important characteristic should be

a single integrated risk platform that will allow the CCP to aggregate and monitor total exposures across

all exchanges and markets. The best risk solutions will also comprise an adaptable architecture, a broad

range of risk methodologies, the ability to measure risk in real time, comprehensive stress-testing and

robust default procedures. This will enable the CCP to be exible, highly responsive, and to scale to keep

pace with product innovation and increased volumes.

We trust that these insights will help CCPs gain a competitive advantage amidst changed market and

regulatory conditions, and ultimately succeed in a new era of risk management.

Sincerely,

Andrew Wood

Chie Executive Ofcer

Razor Risk Technologies

Foreward

Emerging from the nancial crisis: A new era for CCP risk management 1


4/12

Risk management lessons learnt

The credit crisis and the collapse of several

banking institutions have highlighted deciencies

in the understanding of risk and weaknesses

in many of the current approaches to risk

management and the technology solutions used

to measure and control risk. Fundamentally,

a number of organisations failed to have

the necessary big picture view of risk,

and therefore did not practice the required

measurement and control.

The lack of complete and

timely risk management

information not only

contributed to market

dislocations, but also

prevented institutions from

realistically assessing risk.

The separation of market risk and credit risk intosilos, coupled with disparate and fragmented

internal risk systems, acted as a major

impediment to institutions aggregating and

monitoring their total exposures across the entire

organisation.

In addition, risk management was generally

retrospective, rather than proactive and

forward-looking; there was an over-reliance

on quantitative measurement tools without a

complete understanding of their limitations and

assumptions; and there was also an absence

of appropriate stress-testing to help institutions

identify the consequences of unique marketcircumstances.

This lack of complete and timely risk

management information not only contributed

to market dislocations, but also prevented

institutions from realistically assessing their

risk, maintaining appropriate levels of liquidity,

reacting swiftly to potentially adverse or

deteriorating positions and minimising losses in

a volatile and illiquid market.

Risk is an inherent and necessary component

of free markets. It is now one of the top three

concerns for many chief executive ofcers, after

revenue and prot, as they recognise that the

way their organisations understand, measure

and manage risk will help set them apart. While

this is encouraging, recent events have shown

risk measurement and control across the global

nancial community must take a giant leap

forward.

Risk is now one of the topthree concerns for many

CEOs, after revenue and prot.

A growing number of organisations are

taking important steps towards better risk

management, such as: integrating transactions

across nancial institutions so that everything

is in the risk system; revising risk assessment

methodologies to incorporate evaluation of

tail risk from unlikely events; strengthening

liquidity risk management; appointing external

risk managers to report on risk managementsystems; and linking remuneration to responsible

risk management.

There needs to be a

fundamental cultural shift

towards viewing risk as the

responsibility of the entire

organisation.

While these changes show risk is starting tobe given the priority it warrants, organisations

need to move beyond applying tactical xes to

address structural and operational shortcomings

in isolation. There needs to be a fundamental

cultural shift towards viewing risk as the

responsibility of the entire organisation. This

holistic approach to risk management will see

a risk culture established at board level and

ensure the appropriate specication of risk

appetite, forecasting methodologies, information

technology, infrastructure, reporting and

processes embedded throughout the institution

and its operations.



5/12

Enhanced role for CCPs in achieving

market efciency and stability

In addition to changes at an institutional level,

international regulators and policy makers

are also looking for solutions to minimise

future market dislocations. While there are

many nancial sectors under consideration,

a signicant development is international

proposals to mandate CCP clearing for OTC

derivatives.

Arguably, the lack of uniform, transparent and

centralised collateralisation for many OTCderivatives deals played a prominent role in the

recent credit crisis. This has driven regulatory

proposals to capitalise on a CCPs ability to

provide improved transparency, centralised

collateral management and increased nancial

transaction efciencies, with the ultimate

objective to minimise and better manage

counterparty risk. If achieved, this will assist to

mitigate global systemic risk.

It is likely CCPs may one

day be involved in a greater

majority of all transactions.

While regulatory proposals are still in ux across

many regions (see Key Regulations sidebar on

page 4), new market conditions have created

a number of opportunities and challenges for

CCPs. Growth opportunities currently stem

from increased volumes as well as expandingproduct range and geographical reach in the

OTC derivatives markets. However, it is likely

CCPs will be involved in clearing the majority

of trading instruments. CCPs may choose to

expand their product range or reach through a

partnership model, acquisition, the capture of

increased market share or organic growth.



6/12

The following is a summary of some of the key

regulatory changes that are shifting the landscape in

which CCPs now operate.

House Committee (US)

In December 2009, the US House of Representatives

passed a plan that included the introduction of

electronic trading platforms and central counterparties.

The nal version of the nancial reform bill, the Dodd-

Frank Wall Street Reform and Consumer Protection

Act, designed to create greater nancial stability,

was passed by US Congress on 15th July 2010 and

signed into law on 21st July 2010. The Act includes

new oversight of the OTC derivatives market, a ban

on proprietary trading by banks and creation of a

new consumer nancial protection bureau to oversee

mortgage and credit-card lenders. The derivatives

legislation set forth in Title VII of the Act includes

a mandatory clearing requirement for the majority

of OTC derivative transactions, with an exemption

for foreign exchange swaps and forwards. The

transaction and pricing data for both cleared and non-

cleared swaps will be reported to a central repository.

Swap dealers and major market participants will have

to adhere to capital and margin requirements.

Many provisions in Title VII of the Act will be detailed

in the ensuing regulatory rulemaking process by the

US Commodities Futures Trading Commission (CFCT)

and the US Securities Exchange Commission (SEC).

The new rules, denitions and studies are generally

required to be completed within 360 days following

enactment.

FSA

In October 2009, following the Turner Review, the UK

Financial Services Authority (FSA) issued its rules on

the liquidity requirements expected of organisations.

These rules narrow the denition of liquid assets;

enhance systems and control requirements; call for

more frequent and meaningful reporting; and demand

that liquid assets be self-sufcient and adequate.

Qualitative aspects of this new regulatory regime have

been in operation since December 2009.

APRA

The Australian Prudential Regulation Authority

(APRA) is set to strengthen its Prudential Standard

APS 210 Liquidity (APS 210) to meet the qualitative

requirements issued by BCBS in September 2008.

This will improve the resilience of authorised deposit-taking institutions (ADIs) to liquidity risk and improve

the regulators ability to assess and monitor its liquidity

risk proles. The changes will also extend cash

ow projection requirements of ADIs to 12 months;

strengthen existing APRA stress-testing minimums;

and standardise the reporting framework for collecting

regular liquidity data, with the ability to access data at

short notice and at times of stress.

APRA will issue new standards and reporting forms on

liquidity requirements by ADIs.

European Commission

The European Commission (EC) adopted a

communication on Ensuring efcient safe and sound

derivatives markets future policy actions on 20th

October 2009. The communication outlined a seriesof policy actions the EC intends to take to address

the problems of OTC derivatives markets, in order

to reduce systemic risk and increase transparency.

These initiatives are in line with the G20 agreement

signed in September 2009 stipulating that all

standardised derivatives should be centrally cleared

and reported to trade repositories by the end of 2012

at the latest and that non-centrally cleared contracts

should be subject to higher capital requirements.

In June 2010, the EC published a consultation paper

on derivatives and market infrastructures that details

how to implement some of the actions outlined in

October 2009: clearing and risk mitigation of OTC

derivatives; requirements for central counterparties;

interoperability; and the reporting obligation and

requirements for trade repositories. The consultation

is the nal step before the EC submits legislative

proposals in September 2010.

Basel II/ Basel III

Basel II is made up of a number of Accords designed

to set international standards and best practice to

dene minimum capital requirements of international

banks. It was developed by the Basel Committee on

Banking Supervision (BCBS).

In December 2009, the BCBS approved for

consultation a package of proposals to strengthen

global capital and liquidity regulations, with the goal of

promoting a more resilient banking sector.

These proposals were endorsed in 2009 by theFinancial Stability Board and the G20 leaders at the

Pittsburgh Summit. They are designed to strengthen

the capital requirements for counterparty credit risk

exposures arising from derivatives, repos and security

nancing activities.

CPSS-IOSCO

The Committee on Payment and Settlement

Systems (CPSS) and the Technical Committee of the

International Organisation of Securities (IOSCO) 2004

recommendations aimed to set out comprehensive

international standards for risk management for CCPs.

In July 2009, CPSS-IOSCO announced a review of

the 2004 recommendations to offer more guidance to

CCPs handling OTC derivatives. The strengtheningof a counterpartys capital requirements under Basel

II is expected to increase the incentives to move OTC

derivatives exposures to CCPs and exchanges.

This review of the 2004 recommendations was fast

tracked and two consultative documents aimed at

strengthening the OTC derivatives markets were

released in May 2010. The rst document provides

guidance on how the 2004 recommendations should

be applied to CCPs handling OTC derivatives; the

second provides a set of considerations for trade

repositories in OTC derivatives markets. Feedback

on the consultative documents will be incorporated in

the general review of the international standards for

nancial market infrastructures that was launched by

CPSS- IOSCO in February 2010.

Key regulations



7/12

While every CCP has its own unique features

regarding risk mitigation, product range,

membership, guarantee, insolvency rules and

default management practices, CCPs will

need to clearly dene their points of difference

if they are to succeed in the new competitive

landscape. These may be based on costs,

products, or services. Leading CCPs will be

able to handle higher volumes at greater speeds;

navigate the interoperability and jurisdictional

challenges of new geographic regions; andappropriately handle the complexity of new

products, while continuing to lower transaction

costs. In addition, time to market remains

extremely important, and will become more so in

the face of increased competition.

For CCPs looking to drive revenue and growth,

this is a critical time to examine their strategic

risk management architecture and core

technology systems. The very nature of a CCPs

risk mitigation role, coupled with the highly

administrative nature of its clearing services,

mean that risk management technology is going

to be of particular importance to success in thisnew market situation.

CCPs will require an ability

to handle higher volumes

at greater speeds...whilst

continuing to lower transaction

costs.

An ability to demonstrate effective and robust

risk management will allay concerns surroundingthe shift of risk concentration from banks and

dealers to CCPs. This will ultimately increase

stakeholder condence. Moreover, a key

component of effective risk management is

the ability to provide accurate and timely risk

analysis to swiftly calculate variation margins and

provide competitive pricing, all while minimising

risk to the clearing house, its members and

markets.

It is vital that a CCPs business

has in place a robust andexible risk management

technology framework to allow

it to adapt quickly.

In this changing and challenging environment,

it is vital that a CCPs business has in place a

robust and exible risk management technology

framework to allow it to adapt quickly.

CCPs need to look at their current risk

architecture to assess their ability to keep pacewith product innovation to easily add new

products, carry out real-time risk pricing and

stress-testing, and conduct initial and variation

margin calculations in order for clearing houses

and their members to effectively manage

counterparty risk. This will enable CCPs to

determine what technological and operational

infrastructure changes are needed to support

business expansion.

Laying the foundations for growth



8/12

Outlined below are seven main characteristics

of an effective risk management technology

system, which can assist CCPs to adapt

quickly to legislative changes as they arise, as

well as other market pressures, in this new risk

management environment.

1. A single integrated high

performance risk platform to

allow the CCP to aggregateand monitor total exposures

across all exchanges for all

products

Previously, some organisations compromised

between speed-to-market and an enterprise-

wide view of risk. A successful CCP must have

both.

A single integrated risk platform, with all

transactions on one system, enables a CCP to

calculate its total exposure and aggregate andmonitor client positions across exchanges and

clearing houses. It allows these exposures to

be updated in real time as and when required.

Through the one platform, the CCP can provide

comprehensive collateral management and

conduct appropriate modeling and analytics

to ne-tune initial and variation margin

calculations for specic members. Moreover,

this consolidated view enables a CCP to exibly

measure concentration points across any

number of factors such as markets, regions, or

sectors.

The architecture and data framework of aneffective single integrated risk platform will

ensure that a CCPs product innovation can

keep pace with risk technology and analytics.

A CCP needs to have the adaptability to easily

add new products, pricing algorithms and

risk analytics relevant to all required markets.

The lack of data replication and duplication of

integration inherent in a single system with a

modern, scalable and distributed architecture

also provides signicant performance,

implementation and ongoing support

advantages.

2. An adaptable architecture

to enable the CCP to respond

to business, market and

regulatory changes

A modern and scalable architecture that

is aligned to service-oriented architecture

principles, and is based on open standards, will

provide the adaptability required to competesuccessfully as a CCP. Such architecture offers

the accessibility and interoperability required

to simplify any complex issues arising from

integration with other systems. The addition of

new functionality is also made easy, with minimal

system redevelopment required.

Each CCP has unique features regarding

risk mitigation, product range, membership,

guarantee, insolvency rules and default

management practices. Therefore, an integral

part of the architecture of an effective risk

management technology solution should be

the capability to support customisations andcongurations in order to fully represent the

individual characteristics of a CCP. These

should comprise user-dened data types

and plug-in support for pricing, market and

simulation modules.

A recommended design format is metadata,

which provides the adaptability to fast track

implementation and provide the CCP with a

more functional end solution. Such models have

the exibility to add, edit or delete data by simply

rening the metadata; these changes are then

available in the database, the graphical user

interface and the services, with no modicationof the code required.

An adaptable architecture should fully utilise

commodity hardware to enable the rapid

processing of intensive scenario and stress-

testing simulations. The right architecture

should also provide a balanced, modular and

distributed processing capability, such as grid

computing, which efciently organises all risk

valuations over a network of servers. This

delivers high performance and scalability at a

fraction of the cost of alternative technologies.

In addition to providing scalability across servers,

the architecture must also scale to increasecore density per server in order to achieve the

Key characteristics of an effective risk

management technology solution



9/12

optimal parallel processing power and enable

the CCP to meet any existing and future volume

and performance requirements. CCPs will be

able to handle the speed and complexity of risk

analytics calculations required for high-volume

high-frequency standardised products, as well

as low-volume complex products.

3. Multiple risk methodologies,including Value at Risk (VaR),

utilised in the correct manner

to achieve accurate and more

relevant modelling

A best practice risk management technology

solution must support a broad range of risk

methodologies to provide a more balanced

guide. The use of a range of risk measures

enables CCPs to measure the risk of default

across all or single exchanges, depending on

the characteristics of the instruments traded.

The system must also be able to drill down to

identify and understand the drivers of underlying

variations in the risk calculations.

The CCP must have the capability to easily add

new risk methodologies or to assign specic

existing methodologies to meet certain tasks,

such as assessing the exposure to House and

non-House positions. In addition, the ability

of a technology solution to add or update risk

methodologies to improve accuracy has never

been more important particularly with the

recent focus on VaR and its failure to signal

outcomes during the nancial crisis. Too often,

inaccuracies result from assumptions or a failure

to incorporate real-world risks or adequate

stress-testing.

In the case of VaR, a CCPs risk management

technology solution needs to be able to

go beyond point in time and incorporate

a forward looking calculation over a multi-

period basis, allowing for dynamic changes

in the underlying portfolio holdings, such as

trades maturing, cashows being reinvested

or options being exercised. The technology

must also allow extensions to market risk VaR

models to incorporate credit defaults, as these

best capture non-normal events faced by

institutions today, and incorporate macro cyclical

macroeconomic stress-test factors.

4. Measure risk in real time sothe CCP can quickly resolve

outstanding positions in

stressed and volatile conditions

In the past, institutions have compromised

between speed and accuracy of calculations.

For many instruments, risk determination is

a time consuming exercise. An effective risk

management technology solution should be able

to provide CCPs with the capability to make

decisions as quickly and accurately as possible,

in order to reduce exposure to potentiallydefaulting members. The time it takes to

convert data into interpretable and relevant

information that can be used to make decisions

that is, the relevant time needs to be as

quick as possible. For a CCP, this relevant time

is typically real-time.

A distributed computing architecture will provide

the computational power to support the efcient

intra-day or real-time processing of business-

as-usual activity for the CCP. However, the

risk management technology solution must

also have the capability to provide ad-hoc and

immediate risk analysis should an unexpectedevent occur in the market.

High performance real-time monitoring provides

the CCP with the opportunity to call margins

when required, rather than having to wait until

the end of day or longer. This greatly reduces

risk exposure to relevant members.



10/12

5. Comprehensive stress-testing

to assess the adequacy and

liquidity of nancial resources

To measure and manage risk accurately in a falling

market, a CCPs risk management technology

solution must provide exible and comprehensive

scenario simulation and stress-testing across thebusiness. For liquidity risk, the solution must be

able to generate all required cash ows through

time, as well as the risk drivers across all asset

classes, including non-linear OTC derivatives.

A CCPs risk management technology solution

must enable what-if analysis on a market,

trade or position level, which can be used to

understand potential exposure if a member

defaults in a falling market. Again, the solution

needs to have the capability to deliver this

information in real time, to enable a rapid

response.

The right stress-testing functionality should have

the ability to apply shocks to the risk drivers

across the complete data set. It should also be

able to incorporate dynamic changes to portfolios

over time, as well as alterations to market data.

Portfolios or trades should be able to be repriced

accordingly, taking into account factors such as

trades rolling off, and coupons and swaptions

being exercised. The CCP should also have the

exibility to modify, or apply new stress scenarios,

should market events require the monitoring of

specic asset classes.

6. Support risk mitigationactions with the ability to set

and monitor default procedures

to contain and eliminate

exposures to a defaulting

member

Each CCP has its own set of default procedures

to guide decision making should a default

situation arise. However, in a system that holds

all relevant trading and collateral information, it

is equally important that the CCP can exercisethese procedures to ensure their relevance in a

changing market.

A CCPs risk management technology solution

must be able to model scenarios and the resulting

risk measurements outside of the day-to-day risk

monitoring activities. Exercising these default

procedures within the technology framework

itself, helps eliminate any exposure to a defaulting

member, while actively monitoring regular member

activity.

7. Clearing risk solutions to

manage the default risk of

members and their clients

At a minimum, CCPs require full transparency of

exposure to their clearing members, to view all

relevant information and be ready to take recovery

action if a default event occurs. However, it isunusual for the CCP to have the same level of

visibility for its members clients, meaning many

CCPs lack access to important information when

monitoring for the potential for default. Where

client member data is available, the best risk

management technology solutions will have the

capacity to calculate risk models relevant to both

the CCPs members and its members clients.

This provides a vital layer of overall risk mitigation

to prevent future systemic risk.



11/12

Risk is an inherent and necessary component

of global nancial markets. Recent events

have demonstrated that the way in which

nancial institutions measure and manage risk

will differentiate them in what is an increasingly

competitive landscape.

In particular, CCPs are under increased scrutiny

because of regulatory proposals that will see

them take on an enhanced role in providing

market stability and efciencies in nancialmarkets. This changed regulatory environment

provides signicant growth opportunities for

CCPs, as well as unprecedented challenges and

competition.

This paper has illustrated the signicance of

effective risk management and core technology

systems to the success of a CCP in this new

era of risk management. An important rst

step for any CCP planning to excel in the

changing regulatory and market conditions is

an assessment of its current risk management

architecture and technology infrastructure.

This paper has outlined some key characteristics

of an effective risk management technology

system, which will hopefully assist CCPs in

adapting quickly to new market pressures and

legislative changes as they come into play.

These issues are likely to increase in complexity

in an evolving global economy. It is therefore

more critical than ever for CCPs to implement

changes now or risk being left behind.


Conclusion


12/12

measure & control your risk

Contact us

Australia

Level 9, 115 Pitt StreetSydney NSW 2000 [email protected]

+61 2 9236 9400

Europe

8th Floor, 145 Leadenhall Street

London EC3V 4QT UK

[email protected]

+44 (0)20 7621 8520

Americas

276 5th Avenue, Suite 901

New York NY 10001 USA

[email protected]+1 (212) 683 9445

About us

Razor Risk Technologies is an Australian public company

(ASX: RZR) focused on assisting nancial services institutionsworldwide to measure and control risk through professional

services and its enterprise risk management product, Razor.

The company specically addresses the complex issues

surrounding risk management issues that were highlighted

during the economic downturn with the collapse of institutions

such as Lehman Brothers. Razor Risk Technologies recognises

that in order to measure and manage risk effectively, its

necessary to manage the total exposure of a nancial institution

across all its global activities.

With ofces in Sydney (headquarters), Melbourne, New York

and London, Razor Risk Technologies has a highly skilled

team of specialists who provide risk management technology

and consulting services across the nancial markets and risk

management sectors. The company operates on a global

risk consultancy structure, drawing upon the expertise of allemployees in implementing best practices for clients individual

needs. This methodology supports an efcient, low cost, minimal

risk implementation, allowing clients to maximise optimal risk and

reward. Razor Risk Technologies has a 100 per cent successful

implementation record for its product, Razor.

About Razor

Razor Risk Technologies award-winning Razor framework

provides near real-time and pre-deal calculations that enable

management to view their total exposure to individual entities

on one consolidated platform. Clients use Razors advanced

analytics and scenario calculations to achieve best practice in

managing risk exposures for credit, market, clearing and liquidity

risk within a single application.

Since Razor is a framework and not a risk measure, practitioners

can easily incorporate new sources of risk and accommodate

innovations in best practice risk management. Razor also assists

nancial institutions to satisfy their requirements under the Basel

Regulatory Framework and the CPSS-IOSCO Recommendations

for Central Counterparties.

Razor has helped improve the way Central Clearing

Counterparties, Stock Exchanges, Banks, Hedge Funds and

Brokers across the globe measure their risk and manage their

capital. Razor is the leading risk management framework

around the CCP12 members, the industry association of the

worlds principal clearing organisations, and is used by ASX in

Sydney, LCH.Clearnet in London, IDCG in New York, and KPEI in

Indonesia.

www.razor-risk.com

2010 Razor Risk Technologies. All Rights Reserved. R07/10 v2.

Whitepaper CCP R0710 v2

Documents

Transcript of Whitepaper CCP R0710 v2