Challenges in the front office

Evident during the recent financial crisis, and in the context of current regulatory reform, is the high level of systemic risk that exists as a by-product of the use of over-the-counter (OTC) derivatives. This article assesses the front-office tools needed to effectively manage their use, and previews the potential effects of changes in market structure on the IT demands of the front office.

While much maligned given their role during the crisis, OTC derivatives, when used properly, will continue to be powerful tools to manage investment risks and structure portfolio strategy. While OTC derivatives did not cause the crisis, the inter-connected financial obligations between organizations due to their use did cause a near financial system meltdown.

The Dodd-Frank Act, signed into US law in 2010, covers many aspects of financial reform, but has a clear goal of reducing, or at least controlling, the amount of systemic risk in modern markets. By June 2011, US agencies affected by the legislation, notably the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) but also in concert with international agencies such as the UK’s Financial Services Authority (FSA), must add substance by putting into place rules and structure to underpin the legislation.

An increased focus on risks, and lessons learned, will lead to a push for IT to provide tools that allow for a greater understanding of current risks.

Most of the efforts made by global regulators are meant to instil confidence in the system and boost  transparency and liquidity. Many reforms try to reduce the opacity of sell-side trading operations and mitigate counterparty concentration risks brought to light since 2006. While the effects on the sell-side are more drastic, the buy-side can expect more direct changes as Swap Execution Facilities (SEFs) and Central Counter Parties (CCPs) come on line. The goal of reducing systemic risk may be clear, but the timing of these changes is not. This creates an ongoing challenge not only for market participants but also for those who manage the investment management systems that participants will use as the market adopts new styles of trading and absorbs new reporting requirements.

Another key challenge for investment management system managers in 2011 comes from the continued use of OTC derivatives by the front office during the transition to a new market structure and as the goal of a stable, robust and liquid market is realized. To use OTC derivatives appropriately now and in the future, the front office needs tools that offer a clear understanding of exposure to risk, leverage, and counterparties, given the complexity and inter-connected nature of the modern financial markets.

Key items to address in 2011 for those who manage software systems that support front office OTC derivative operations are:

• Transparency and control over applications that describe exposure, provide valuation and calculate risk;
• Flexibility in on-boarding new workflows into existing front-office applications.

Exposure toolbox

OTC derivatives are indeed complex, both in their structure and in their impact on the investment portfolio. The basic assessment to make is: does the front office have all the tools necessary to determine their various exposures to risk? Does the front office use disparate platforms to manage investments leading to an inability to holistically review risks? An increased focus on risks, and lessons learned, will lead to a push for IT to provide tools that allow for a greater understanding of current risks.

The old standards sought to measure weights in classifications such as currency, credit ratings and issuer exposure. With the increased complexity of the markets, that definition must extend to include counterparty and leverage, but also measures that capture non-linear returns and specific risk-exposure characteristics of certain security types.

Counterparty exposure

Counterparty exposure is not as simple as keeping track of those with whom you trade. Any OTC transaction will involve counterparty risk, as the potential payment of profits will directly involve their ability to pay, or even, as after the bankruptcy of Lehman Brothers, to retrieve pledged collateral against trading activity. Before the crisis, counterparty exposure analysis aggregated all exposures due to trading activity, performed stress tests on likely profits expected, then assessed if any party was overexposed. The front office would then be instructed on future actions to lessen this risk.

But now, financial accounting standards like IFRS 7 and Topic 820 (formerly FAS 157) are driving the demand for transparency by incorporating a Credit Value Adjustment (CVA) directly into the reported fair value of derivatives, meaning all fair market or exit values must expressly capture the monetized value of the counterparty credit risk. With this move, counterparty risk is no longer a pure middle-office task; pre-deal calculation of CVA affects valuation of current holdings, modifies collateral requirements and dictates preference in trading partners.

Directionality of exposure

Exposure is also a factor of leverage, as any derivative – either exchange-traded or OTC – will increase exposure to certain risks without a cash outlay to actually purchase the underlying security. A key tool to assess the degree of leverage is Synthetic Cash (also known as Virtual Cash) – the amount of capital saved by transacting in a derivative versus a direct purchase of the underlying security, index or risk factor.

The challenge for the front office (assuming the OTC market continues to offer the current breadth of products) comes from the complexity of intelligently representing the single risk factor directionality of multi-leg OTC derivatives.

For example, a purchase of a bond future will add sensitivity to interest rates while only requiring margin to gain that exposure. Visualization of the cash effect is more effective than simply aggregating notional amounts since fair values, non-linear measures (such as delta), and contract details, will affect how much cash replicates the exposure. By measuring the total amount of Synthetic Cash, the degree of leverage in the portfolio can easily be compared to assets under management to understand how aggressive, or hedged, the portfolio actually is.

Directionality of derivatives is also a key aspect of understanding risk and exposure. Selling an index future has a direct impact on lowering exposure to systematic risk present in equities, just as entering into a Pay Fixed Interest Rate Swap lowers exposure to rising interest rates. The challenge for the front office (assuming the OTC market continues to offer the current breadth of products) comes from the complexity of intelligently representing the single risk factor directionality of multi-leg OTC derivatives.

The funding leg of a Total Return Swap (TRS) or Credit Default Swap (CDS) must be captured since they have a direct affect on cash flows (and the yield) of the portfolio; but the exposure leg must clearly affect a change in exposure to specific risk factors. Buying credit protection through a CDS has only a small exposure to changes in interest rates (through the funding leg), but a large effect on credit exposure, just as an Inflation Swap offers exposure to future levels of inflation. True transparency into exposure comes from a granular approach to risk profiles, and proper aggregation into specific risks that affect the investment portfolio.

Credit ratings and credit spreads

Another effect of the financial crisis concerning all market participants, and also covered by the Dodd-Frank Act, is regulation and the role of rating agencies, their business model and the efficacy of their credit analysis. Even above the apparent conflict of interest of having issuers pay for bond ratings is how useful these measures are. Markets move faster than revisions of credit ratings, so incorporation of measures of credit worthiness must come directly from market sentiment as represented by spread levels in the credit markets.

Assessing relative value of bonds via observed spreads is a core component of trading credit and is a staple of any front office system. What will change from 2011 onwards is the use of spreads and ratings in an increasingly complementary fashion. More and more, spreads will offer a dynamic assessment at what level a credit should trade, rather than where the agencies believe it should. Bonds and CDS s trade in related, but distinct markets. The crisis brought to light how quickly the CDS market assesses changes in credit compared to the slow process of reviewing credit ratings. Measures such as implied CDS par spreads bridge this gap by measuring the credit spread of a bond implied by trading activities in the CDS market, and increases the ability of the front office to respond to changes in market sentiment across issuers and industries.

Workflow management

Perhaps the greatest change possible for those who trade derivatives will come as rules related to the Dodd-Frank Act and similar mandates overhaul the way swaps are traded, moving from opaque bilateral trading into a transparent, centralized and standardized model.

Overhaul of the market

While Dodd-Frank attempts to reduce the systemic risk inherent in the trading of OTC derivatives, it only sets the foundations for this new structure, not the specific details, as seen in this excerpt from the Dodd-Frank Act:

"... an electronic trading system with pre-trade and post-trade transparency in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the system ..."

It is to be noted that Dodd-Frank does not specify execution method or price discovery mechanics of the Swap Execution Facility (SEF), nor if this is simply a new name for existing providers. As the CFTC clarifies the rules governing SEFs, it will be defined how prices are negotiated. In terms of price discovery, the method chosen will have a direct effect on current front-office systems if straight-through processing (STP) is an organisational goal. For example, a ‘request for quote’ is similar to how bonds trade electronically and is supported by messaging protocols such as FIX. But supporting STP for swaps means either adopting a hybrid communication model (using FIX for execution and F pML for security structure) or supporting a new version of FIX that directly supports this process (i.e. FIXML).

Central clearing

Another aspect of the legislation is a move away from collateral bilateral trading into a margin-based model using SEFs for execution and price discovery, and an exchange-style Central Counterparty (CCP) to limit the exchange of collateral and mitigate systemic risk. Regulators must also determine what must be cleared through a CCP and therefore traded through an SEF in order to meet transparency requirements dictated by Dodd-Frank.

The Office of Financial Research (OFR), a new US Treasury office created through Dodd-Frank, holds the mandate for monitoring systemic risk and will rely on the Depository Trust and Clearing Corporation’s (DTCC) global repository for OTC derivatives data stored in its Trade Information Warehouse (TIW). F or swaps traded through SEFs and cleared though CCPs, this transfer will depend on the ability of either the CCP, or the trade processing segment of the SEF, to pass data to DTCC. For OTC trades outside that framework, investment managers will continue to pass that data directly to the DTCC (see Figure 1).

Margin management

Whether or not investment managers will accept using cash as margin in lieu of investment opportunities, a review of systems used to manage margin is warranted. Often different asset classes use specific tools that take into account the intricacies of that market. A bespoke system that manages collateral due to repo trading may not be suitable for handling collateral from trading OTC derivatives. The more asset-specific systems are used, the greater the challenge of obtaining a true cross-asset, cross-function, firm-wide perspective on collateral and margin, and the slower the front office will be in responding to dynamic market events.

The devil is in the details

An overhaul of the system that drives the OTC derivatives market, through Dodd-Frank and associated rules, offers an opportunity to review, and possibly retool, the applications the front office relies upon to manage investments. At this stage, more is unknown than known, and the main focus over the next year will be to stand ready to adopt the changes in market form and structure, while continuing to manage the risk inherent in the current system.

An overhaul of the system that drives the OTC derivatives market, through Dodd-Frank and associated rules, offers an opportunity to review, and possibly retool, the applications the front office relies upon to manage investments.

Investment managers must keenly regard the renovations needed as work in progress and determine if the trading of OTC derivatives will be too complex, cumbersome and costly to continue to take advantage of their usefulness in portfolio strategy and hedging, and whether or not their front-office investment management system is ready for this brave, new world.