Following the economic crisis, financial institutions are looking to reinvent their business models for capital markets activities. They are now exploring fresh, innovative organisation structures along with investigating how technology can empower risk, operations and trading functions. This fundamental shift is particularly apparent in the context of risk management.
Banks and buy-side firms now understand the need for a much stronger control framework, especially for liquidity risk and counterparty credit risk. Managing these risks efficiently requires a holistic approach. Firms need to be able to monitor all exposures, across desks and entities, on an intra-day basis and ideally, in real-time.
The colossal regulatory shake-up that followed the crisis is fundamentally reshaping derivatives markets.
Hard-hitting regulations, such as the Dodd-Frank Act and EMIR, are forcing a large portion of OTC derivatives trading onto central clearing counterparties and are imposing systematic over-collateralisation to eliminate counterparty risk. This is costly as it requires the mobilisation of large pools of assets.
No discussion of the regulatory landscape would be complete without acknowledging the work of the principal global standard-setter for the efficient regulation of banks – The Basel Committee. The Basel Committee has been revamping its Capital Adequacy Framework, deploying an extensive array of complex (and costly) rules which are driving banks to significantly deleverage their trading book activities.
How can financial institutions cope with these changes?
An efficient strategy to address the new risk and regulatory paradigm requires a holistic approach to regulation as well as a willingness to reposition and optimise resources.
A holistic approach to regulation
Until recently, many institutions relied on ad-hoc solutions, focusing on individual pieces of regulation rather than the regulatory environment as a whole. There is a growing realisation among the leaders in capital markets that this is not a sustainable approach.
Many of the highly complex upcoming rules, including the Fundamental Review of the Trading Book (FRTB), have a significant impact on a bank’s infrastructure requirements. With a growing regulation burden, there is a pressing need for banks to reduce the cost of risk IT. Leaders in the industry understand that in order to increase operational efficiency and create cost-reducing synergies, they need to break their traditional business and technical silos.
Reposition and optimise resources
In recent years, capital markets have seen liquidity risk, credit risk and the cost of capital become the main drivers of profitability in capital markets.
In response to this significant development, financial institutions are rethinking their business processes. Many have started regrouping traditional trading silos in order to manage risks effectively and centrally. Where synergies are identified, business areas can be regrouped to improve efficiency. Those who move to a risk-based pricing organisational model will develop a significant competitive advantage.
The next step for financial institutions is to identify unprofitable business lines. By shutting down or outsourcing unprofitable business lines, financial institutions can focus on areas in which they offers a unique expertise and thus, preserve their profit margins. Among the key actors in capital markets, a trend has developed of merging margining operations of previously independent business lines, such as securities lending, central clearing, listed products and uncleared OTC derivatives, to create central collateral trading units.
Once actors in the capital markets take the measures described above, they can then begin to develop efficient risk optimization strategies. For example, they could start valuing the incremental funding cost of collateral on a pre-trade basis. This would allow an institution to choose the cheapest clearing execution venue or to charge back CVA (the cost of credit) to trading desks. In order to achieve this, significant investment in trading and risk infrastructure is required, as sophisticated risk management computations now have to be run at every step along the trading value chain.
How advanced is the IT transformation process?
Today, most financial institutions are still struggling with the rationalisation of their IT infrastructure.
In order to understand why this is the case, it is necessary to examine the two key roadblocks on the road to IT Transformation:
The first challenge facing financial institutions active in capital markets relates to the inefficiencies of risk systems and data management processes that became apparent in the aftermath of the financial crisis. Over the past decades, an IT landscape of siloed systems has developed without a coherent enterprise vision or sufficient attention to data quality management.
Very often, risk data is gathered from diverse source systems running slightly different calculations based on inconsistent parameters. These results are then fed through spaghetti interfaces to legacy reporting engines to be reconditioned and aggregated into global exposure reports. The data sets are often incompatible or out-of-date, which can be due to a lack of well-defined repositories, duplicated data or outdated technology.
As a result, considerable energy is being spent on complex and costly reconciliation processes, at the expense of timely and reliable risk analysis. Late and incomplete risk figures make it hard to make any decision in confidence; the entire framework is expensive, operationally risky and, of course, an obstacle to evolution.
While both banks and regulators recognise this, decommissioning ageing legacy systems, sorting out the data and system ownership questions, and migrating activities onto broader integrated trading and risk platforms takes time.
The second challenge institutions are facing is the daunting computational burden that accompanies the new risk measures and capital calculations. For instance, pricing XVA for new trades means running Monte Carlo simulations that require millions of re-pricings in a matter of seconds. To achieve this, institutions need to invest in disruptive technology and high performance computing techniques, such as massive parallel processing, in-memory aggregation or specialised processing chips, like GPUs.
How can technology help?
Market participants demand a risk management infrastructure that is highly adaptable and fully real-time enabled.
Risk managers are asking how they can control a continuous stream of complex regulations and adapt to future regulatory demands in an innovative and effective way. They also need a more reactive risk management framework to deal with unforeseen market shocks, such as a “flash crash” events or the sudden evaporation of market liquidity. In this context, our firm belief is that risk technology can stop being an obstacle and become a business enabler as well as the key to improved competitiveness.
As a result, leading technology vendors have seen a growing interest in the application of new technologies in the area of financial risk management, particularly big data techniques, in-memory analytics, GPUs and cloud-based services.
In the coming years, Murex expects that there will be a redefinition of the collaboration model between technology vendors and banks. Financial institutions want to build long-lasting partnerships with technology vendors they can trust. Such partnerships will result in an effective technology strategy and the definition of a roadmap that will enable financial institutions to safely navigate changes in capital markets.
By Marwan Tabet, Head of Murex Enterprise Risk Product Division.