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James Williams, Hedgeweek

Will regulation help or hinder derivatives risk management?


Managing derivatives risk in the portfolio is a demanding task at the best of times. But as global regulators make inroads to drive transparency in OTC markets, managers find themselves having to file detailed risk positions under CFTC regulations in the US, EMIR reporting in Europe, not to mention the unnecessarily dense Annex IV report under AIFMD. 

Quite what regulators hope to gain by getting such voluminous data remains to be seen. Still, managers must comply. OTC derivatives are increasingly being traded on Swap Execution Facilities (SEFs) under Dodd-Frank, with exchanges such as CME Group rolling out products such as the Deliverable Swap Future, a standardised contract that illustrates a move towards swap "futurisation" and a move away from the opaque bilateral OTC trade environment, which some consider too systematically risky.

The migration to centralised clearing for OTC derivatives has created numerous centralised clearing parties (CCPs). One issue is that different clearing houses are using different models for pricing and margining. Portfolio managers using more than one CCP arrangement need to factor this into their risk management and decision  making.

"The clearing houses are also using different ways to build curves and volatility surfaces which directly impacts collateral valuation, which can further impact price and risk. A swap position in TFG can have a different value depending on where it is cleared and what the customer requires," says Martin Toyer, Chief Technology Officer at TFG Financial Systems. 

"We have one client who wants to match the clearer's price so that they aren't getting a different price when they trade. To support this has required development work for capturing trades from SEFs to dealing with different netting and different valuation models – thereby increasing complexity."

As Georgia Brewster, Sales Manager at TFG points out: "We have tried to enable clients to lead the way on how they would like their portfolio to be managed in this new environment. We're giving them the flexibility with the software to let them contribute a valuation from the clearer, for example." 

In Brewster's view, it's too early to know whether regulation is going to make derivatives risk management any easier or not. The good news, however, is that some firms are developing solutions to make managers' lives easier, specifically with respect to margining.

OpenGamma is a leading provider of OTC market structure solutions. It has worked in collaboration with OTC derivatives market participants to build an open source model to calculate the margin on bilateral OTC trades. The solution will use the final Standard Initial Margin Methodology (`SIMM') developed by ISDA and will be made available to market participants on Github.com, an open source environment. 

This is an important development as the OTC markets adjust to regulation because as highlighted above regarding clearing houses, the derivatives industry needs to instill some degree of standardisation. Otherwise risk reporting and remaining compliant will become an impossible exercise. 

With OpenGamma's SIMM solution, derivatives traders will have access to source code for margining for the first time and allow them to avail of an independent, verifiable calculation framework. It's a loose analogy, but one could think of this as being similar to the creation of the OPERA reporting standard that provides managers with a common reporting framework to use with their investors. 

"With capital scarce, financial firms are more focused than ever on developing high-value, proprietary innovations rather than recreating industry-standard methodologies," said Mas Nakachi, CEO of OpenGamma back in March this year. "That's why we're working with the industry to streamline and democratise the development of market structure solutions, which also fundamentally reduces operational and systemic risk through the inherent transparency of open source code. We believe the future of OTC market structure will be driven by the need for transparency and will therefore be based on open standards."

One firm that has stepped in to the breach to make it easier for derivatives traders to generate risk reports is cloud-based provider, Derivitec, whose central philosophy is to provide its clients with validated risk management reporting. 

At the heart of the Derivitec model is the ability to analyse a portfolio of derivatives exclusively via the web, with no need for users to go through the time and ongoing costs of a system install. This is about leveraging the cloud to optimise portfolio risk management. 

Derivitec generates standard risk reports that include all the usual Greeks one associates with derivative risk, as well as stress tests and will soon be providing historical and parametric (Variance/Covariance) VaR. What is especially powerful, however, is that end-users are able to drill right down into the analytics from which the headline numbers derive. 

This is particularly important for investors and is something that start-up hedge funds, in particular, can use as a real point of differentiation. They could, for example, invite prospective investors on to the platform so that they themselves can check the numbers, look at the underlying risk metrics within the report, and get a deeper understanding of that manager's approach to trading risk. 

Discussing the reporting capabilities, George Kaye, CEO of Derivitec says that the advantage of using a third party vendor is that "we implement the solution for everybody so the consistency checks are much more stringent. 

"Whether it's looking at the Greeks, shock scenarios, VaR, our reports can help risk managers both in sell-side and buy-side institutions. Organisations will have a preferred PMS but we can integrate quite easily to give them the ability to dive deeper into the risk numbers. Given risk can be exposed in numerous ways, it takes the pressure off managers. We are basically filling a gap where clients want to produce certain risk reports from their existing system vendors, but are dealing with much longer implementation lag times. We can overcome that," says Kaye. 

This is one of the benefits of using a powerful cloud-based risk engine. Kaye says that people are speaking to Derivitec precisely because it uses the cloud. 

"For example, we are talking with one prime broker who likes the fact that we operate in the cloud because it allows them to share information immediately with their clients, and in turn allows clients to be responsible for booking their positions. There's greater commonality to discuss prices with the PB, and the fact that there is no software to download makes it a good fit for a lot of people," explains Kaye.

One of TFG's objectives is to provide risk numbers that are explainable and understandable. This means trying to make scenario generation within the system as model-independent as possible. 

"Users can define the `What ifº' event in terms of market shocks, or define it by how much an index or curve were to move and the market were also to move with it in a correlated manner. You can also see what would happen to the portfolio if certain historical events were to be repeated. 

"To present these numbers we use what are known as Mastermind sheets. They have Excel-like functionality that allows you to create a real-time monitor which sits on your desktop to monitor stress tests or factor shifts. You can commingle multiple types of shocks and the numbers can be colour-coded depending on risk levels.

"What we are seeing is clients requesting those risk numbers at different levels of granularity using more complex shocks," confirms Toyer.

Andrew McCaffery is Global Head of Alternatives at Aberdeen Asset Management. Aberdeen will have over USD30 billion in assets under management across its alternatives platform once the acquisition of leading fund-of-hedge-funds manager Arden Asset Management and FLAG Capital Management, a PERE manager, is completed. 

When it comes to risk management, McCaffery says that the team looks at everything from position risk concentration, sensitivity across different parts of the portfolio, the degree to which correlation is increasing or decreasing across strategies, etc. 

"We look at risk factors such as leverage, counterparty exposure, the degree to which we see dislocations in the liquidity profile of the portfolio. Under Basel 3 and other developing regulation, banks will have to be ever more cognisant of where they deploy capital going forward. 

"As a hedge fund allocator, it will become a key issue for us to ensure that the manager's perception of liquidity matches up with the actual liquidity that their banking counterparty can provide. Understanding the liquidity profile relationship between the manager and the prime broker is going to be vital when we move from a benign market environment to a more volatile and challenged one," says McCaffery. 

Aberdeen is in the rather unique position in that it is both an asset manager in its own right, and also an asset allocator. In that sense, the firm appreciates the minutiae of regulation. Its fixed income business, for example, has to comply with EMIR reporting on the derivatives it trades. 

"As allocators, what is key is understanding that the underlying managers meet the regulatory requirements and remain compliant. There are potential costs of failing to accurately report that could potentially impact a manager's strategy," comments McCaffery. 

Asked whether the added transparency of OTC clearing under EMIR and Dodd-Frank could help or hinder Aberdeen in respect to risk management, McCaffery raises an interesting point. Will managers benefit from increased visability and transparency in the way they trade derivatives or will they be at a disadvantage precisely because the opaqueness of the OTC derivatives markets has, up until now, been a cornerstone of how they generate alpha in the strategy?

"There's no easy answer to that at this stage as people are still adjusting to regulation. The challenge for us is to understand the dynamics of derivatives regulation and moreover, be comfortable knowing that the underlying manager is well placed to understand it. How is it changing the way they operate as OTC derivatives starts to move towards more of an exchange-traded environment? We want to be clear that we understand how the manager might be impacted," explains McCaffery. 

One potential unintended consequence of Basel 3 regulation is that it could actually push fund managers to trade more synthetic derivatives such as equity swaps as these contracts reduce the impact on a prime broker's balance sheet. 

Equity swaps are notoriously complex so having a common platform where people can deep dive into the details of a trade and get comfort that the price and risk is correct, is clearly an advantage. 

"When it comes to understanding the minutiae of a synthetic trade it's going to be a lot easier using a system like Derivitec than passing spreadsheets around," suggests Kaye. 

McCaffery notes that synthetic equities usage is probably increasing at the margins because of higher financing costs that managers are facing to trade physical stocks. 

"There's a price to pay for going down the synthetic and structured products route, however. It comes down to the sophistication of a manager's pricing versus the investment bank they are trading with. Under stress, what is the cost impact going to be? How will it change the liquidity profile? Managers who are well experienced at trading derivatives might see it as an opportunity but they need to understand what the incremental benefits will be from a cost and liquidity perspective under different market scenarios – not knowing this could seriously impact the performance of the strategy," warns McCaffery.

Ittai Korin is the President of PortfolioScience in New York. The firm's RiskAPI service is a fully hosted and customisable risk solution and has been designed such that it can cope with the extra demands of regulation. 

"From a usability perspective, if a risk manager or a trader comes to us and says, `I want to be able to run risk analytics on equity options', we have to provide a full picture of their exposure. It's not therefore a case of reacting to regulation and thinking, `Right, we'd better add greater capability for our clients'. The fact is, we have to do that anyway, even if there was no regulation. 

"What drives our product development is the demands of our clients; does our system functionality help them to better understand their risk exposure in a given asset class? We don't get too caught up in what regulators are saying. That is why whenever we release something it is always very detailed and robust from an analytical standpoint," states Korin. 

That said, PortfolioScience is seeing more demand for real-time risk coverage from sell-side institutions. Whereas previously they might only have looked at one level of output, now they are asking what other models they should be looking at in parallel; i.e. not just one type of volatility, not just one type of stress-test, not just looking at the top five positions in the portfolio but looking at everything. 

"They are coming to us and asking how they can get complete visability into everything that passes through their desk. That's definitely a big change in mindset. Maybe it's driven by regulation but it will almost certainly also be driven by not wanting to lose money," concludes Korin.

Gaining greater insights into derivatives risk and using standard models for calculating initial margin will certainly help managers improve their risk processes under evolving regulation. However, whether the transparency of OTC markets will dampen the ability for managers to generate alpha is the USD64,000 question. Only time will tell

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