By James Williams – Akin to the multi-headed Lernaean Hydra faced by Hercules, managers and technology providers alike must today find solutions to control the multi-headed beast that is risk management.
Risk means different things to different people. But to summarise the key components, it now encapsulates: liquidity risk, market risk, counterparty risk, operational risk, regulatory risk, and more recently, sovereign risk.
Five years ago, the idea that Western governments could present a meaningful risk to how hedge funds trade was folly. With the eurozone meltdown, folly has become fact. This illustrates just how complex and self-evolving “risk” is in financial markets.
Technology is integral to helping managers keep ahead of the risk curve. One of the main catalysts behind re-shaping the risk environment is market regulation.
The Dodd-Frank Act and CFTC regulation in the US is pushing the envelope and requiring hedge funds, seemingly overnight, to completely overhaul their approach to collateral and margin management. What was once a simple bilateral relationship with their brokers for the purpose of trading OTC derivatives is now set to become a complex web of counterparty relationships with CCPs, requiring every OTC contract to be cleared and margin posted.
The ability, at the pre-trade level, to estimate initial margining is a paramount concern and one that Misys has moved quickly to address within Sophis VALUE, the firm’s front-to-back integrated platform.
“Right now it’s difficult for fund managers to anticipate how much initial margin will be called by the prime broker because the calculation performed by the CCP will rely on risk-based analytics (e.g. historical VaR).
“Our risk management engine is embedded in our collateral management tool to provide managers with an estimation of initial margins. Knowing how much margin will be called and whether they have enough liquidity to cover the margin call will be vital for managers’ collateral management process,” explains Jerome Lafon, buy side product manager at Misys.
This is as much of an operational risk concern as it is regulatory. And in Lafon’s opinion, systems that provide integration across all asset classes will be necessary for managers to navigate the risk waters going forward. The point he’s making is that having the capability to estimate pre-trade initial margining is not a one-off exercise.
“It requires a collateral management solution, a simulation tool, and a risk management system that plugs in to the portfolio management system. You need to have all the building blocks in place for consistency of data. Without that, there’s no way your risk system will be using the same data and have the same pricing libraries as your portfolio and collateral management tools.”
Imagine Software has been providing front-to-back real-time portfolio and risk management solutions to the financial community for nearly 20 years.
In response to CFTC regulations that come into effect this June, the firm has developed a product for clearing houses (as well as prime brokers and asset managers) to achieve the high speed/high volume risk analysis they will need to help establish risk-based limits – and monitor those limits thereafter – under CFTC Rules 1.73 and 1.74.
The Imagine High-Volume Risk Management (HVRM) solution (which is cloud-based) will be able to perform risk calculations on thousands of trades per second and is, in the words of Imagine CEO, Dr Lance Smith, “blindingly fast”. Such enormous structural shifts in market regulation – and the impact this has on risk management – are certainly keeping firms like Imagine busy.
“The margin rules for IRS, for example, are based on a five-year historical simulation. Under new regulations the clearing houses have just 60 seconds to decide whether to accept or reject the trade.
“That’s a massive amount of yield curve data to work with, so we’ve had to rise to the challenge to deliver those calculations using creative technology and immense processing power,” explains Smith from New York.
As mentioned, buy-side firms, who have come to rely on Imagine’s expertise in real-time risk analytics, are benefiting from this enhanced capability. Imagine has built a series of bespoke margin calculations using house rules from prime brokers and exchanges for its clients to use. “Portfolio managers want to be able to adjust their positions if a margin call is imminent or a contract is about to expire, etc.
“Having an intraday margin calculation means they can avoid that margin call by putting on new trades to potentially bring it down,” adds Smith.
One of the dangers of having too many risk metrics popping out of a trading screen is that traders become distracted. How are they supposed to make sense of these figures? At the basic level, they want to see correlation between asset classes in the trading strategy – or, in the case of a fund of funds, across the underlying managers in the portfolio – historical VaR, and position-level VaR.
While VaR is undoubtedly important, it is ultimately a backward-looking tool. Today’s CRO or COO has to have a multi-dimensional appreciation of portfolio risk. That requires combining forward-looking metrics with the likes of VaR.
“VaR is analogous to skiing downhill backwards. We allow clients to run stress tests for a range of different market scenarios. The ability to run these forward-looking scenarios is essentially the antidote to backward measures such as VaR,” says Smith, adding that the firm has worked diligently to develop data visualisation tools to help portfolio managers manage multi-dimensional risk data more intuitively.
“We have heat maps where sector exposures are laid out clearly. For example, if you are a long/short equity manager, deep red will indicate significant short exposure, deep blue significant long exposure. You can then click on the heat map and drill down to interrogate the underlying figures.”
One of the key tools in the reporting and analytics toolbox at ConceptONE LP, another US-based risk and portfolio analytics firm, is risk budget (volatility sizing). The idea behind this is to help manage performance swings across all market/performance cycles, relative to both market conditions and the objectives and constraints of the portfolio in question, and is, says the firm’s COO, William Livingston, one of its most effective risk tools: “It does this by quantifying portfolio volatility capacity in a way that renders it consistent with incremental loss tolerance. For example, if your maximum acceptable incremental loss is 10 per cent, it would be inconstant with this constraint to experience daily swings of say 3 to 4 per cent. As performance improves, you move further away from this target loss, and volatility capacity increases. Conversely, as losses accumulate, the portfolio moves closer to the maximum negative return threshold, and volatility should rationally be subject to tighter constraints. Our risk budgeting tool captures these concepts in quantitative form.
“What we offer is the ability to monitor both volatility and VaR in parallel with a manager’s P&L, risk budget and portfolio content.”
This is designed to help managers avoid letting risk spiral out of control. But that only works if people are disciplined. Unfortunately, when a trader experiences losses in the portfolio, human instinct is to take more risk, not less. So as useful as risk budgets like the one created by ConceptONE are, they remain at the mercy of the human mind.
The fact that managers are now under more pressure to generate returns necessarily means that more risks are being taken and more complex assets are being traded to find that elusive alpha.
Livingston believes that the real alpha opportunities emanate from traders who manage risk more effectively than their peers during stress events when the risk premium rises and price sensitivities diminish: “Portfolio managers who generate positive alpha during these intervals place themselves in a position by retaining risk capital to reinvest at strategically favorable prices that tend to manifest themselves when those who managed risk less effectively are forced to liquidate their positions at suboptimal valuations. In our judgment, this is a much easier path to positive alpha than superior portfolio construction in stable markets.”
Access to the right data from front through back is an integral part of mitigating operational risk within hedge funds. Not only does it help forge closer, more efficient workflows between the front and back office, it demonstrates an institutional quality infrastructure.
Livingston says that ConceptONE has built a central data repository to satisfy the different reporting needs of managers: be they regulatory or client-based.
The same data that a trader relies on to monitor real-time risk can then be expanded outwards all the way to a summary month-end report to the investors, or even a quarterly Form PF filing.
“We’ve built data models that identify common data elements required by different reports. Our calculation layers are matched to a particular disclosure and pull from a centralised database. This allows us to collect data once and then apply it to multiple reports. Separating data management from specific report responses is the only way to create repeatable and consistent responses across multiple disclosures,” explains Livingston.
Paladyne Systems is a leading OMS/PMS provider to the hedge fund community. In response to the growing need to keep on top of risk management the firm recently rolled out Paladyne Portfolio Risk; a real-time risk analytics solution for the buy-side community. At the same time, it launched Paladyne Risk Master, aimed more at fund administrators to better support their risk reporting capabilities.
“Paladyne Risk Master integrates with our reference data platform as well as our data warehouse and our front-end portal for reporting. Everything is bundled together into one offering for clients to be able to do more ‘risk on demand’, whereby they enter the data warehouse, upload the data, after which the system will run a host of risk reports and analyses as part of a reporting package,” explains Sameer Shalaby, President, Paladyne Systems.
Paladyne’s real-time risk solution is a partnership with Numerix, a firm that had built Numerix Portfolio which uses model libraries to run “What if…” scenarios, Monte Carlo simulations etc. The decision to partner seems to have worked.
“We started integration about a year ago to see if we could fill the risk management gap that clients were asking for. Everything worked out great but I didn’t feel comfortable taking it to market without owning the asset and control our own destiny in supporting it. So we struck a deal with Numerix whereby we agreed to licence their source code while taking on a number of Numerix team members to support our own staff.
“We now have clients using Paladyne Portfolio Risk as a combined solution for front through back and risk,” explains Shalaby who adds that managers will now be able to better control market, liquidity and regulatory risk.
In addition to VaR and stress testing the risk solution offers predictive scenario modelling, sensitivity analysis, credit valuation adjustments (CVAs), potential future exposures (PFE) as well as historical and deterministic analysis tools.
“Post’08 everyone has been focused on developing institutional-grade technology infrastructures and having the right risk tools is very important, in real-time. Managers have to constantly keep on top of risk. That’s why we did the deal with Numerix,” stresses Shalaby.
To underscore the commitment service providers are placing on risk management, Apex Fund Services, one of the industry’s largest hedge fund administrators, established its own technology firm, Apex Technologies around six months ago. The firm takes what managing director Paul Spendiff describes as a “risk tool agnostic” view to support its clients, both large and small.
Not all clients will necessarily need the same level of operational sophistication; start-ups will have less capital expenditure in the early years compared to established funds. But the fact that Apex Technologies works with a variety of risk tool partners, from Linedata to Riskdata and StatPro, means that managers have the capability to develop an institutional-quality operational infrastructure, even if they don’t need to fully utilise it right away.
Without doubt, operational risk is a major issue for managers as they look to stand out from their peers and raise assets. Spendiff sums it up nicely by saying:
“When investors look to allocate to managers they ask themselves, ‘Who can provide us with the comfort that they’re in control of their operational risk infrastructure? Who do we think is scalable?’ A list of 20 managers suddenly becomes 10, and then it’s all about manager rapport and other variables.
“How terrible would it be though, if you were to fall by the wayside for no other reason than there was a perception by the investor that you didn’t quite have the risk controls in place?”