Funding, Credit Risk Efficacy Remain Elusive for Buy Side

As the line between risk management and compliance continues to blur, a major takeaway from last week's IBM-sponsored Waters Roundtable was that effective operational models for credit valuation and funding analysis remain—for smaller money managers especially—highly fraught, and technology providers, seeing an opportunity, are actively listening.

Potential solutions for credit are combating the twin issues of sophistication and cost. Collateral management is a clear and complicated example.

With initial and variation margin being charged across a wider set of over-the-counter (OTC) assets, asymmetric information and modeling capabilities have the potential to disadvantage smaller firms, particularly when they cannot replicate a desired exposure through more liquid, exchange-traded instruments.

IBM's Risk Analytics arm and Markit are independently investigating per-security intermediary services that would provide consistency, if not perfect mechanics, for credit valuation and counterparty risk—a prohibitively expensive process in terms of initial infrastructure spend as well as ongoing data maintenance. Without it, all but the largest buy-side firms will rely on prime brokers for the service. Many will cope with trading inefficiencies as a result.

Just as tricky is the matter of in-house credit analysis workflow. "The idea, since some measure will already be required for new regulatory compliance, is to provide an infrastructure that makes the process transparent: tagging data sources, making modifications and upgrades, and tracking who made what changes through a capital workflow manager tool," says IBM senior director Rustom Barua. "In the end though, it is left to firms to decide where to put in controls in terms of different levels of access to data, and determine how the final content is used."

Those dynamics, says Nomura's executive director of fixed-income technology Paresh Patel, have left the industry with a peculiar conundrum: Two firms, or even two desks within the same firm, using the same data inputs and analytics platform, will often still produce two vastly different risk metrics. But that isn't the worst problem to have. Several participants argue that too few can even afford a platform to begin with.

The one thing that is still missing is a cost-effective, cross-asset solution making public benchmark assets comparable in one system with just the barebones provided for small money managers and more sophisticated instruments and stress tests available on top.

"The one thing that is still missing is a cost-effective, cross-asset solution making public benchmark assets comparable in one system with just the barebones provided for small money managers and more sophisticated instruments and stress tests available on top," says Mark Abbott, head of quantitative risk at Guardian Life.

Joe Sayegh, a portfolio manager with New York State Insurance Fund (Nysif), similarly says that while Nysif can afford a near-seven-figure annual investment in credit analysis and reporting, its current service doesn't easily or exactly produce answers to its commissioners' queries, which will usually have less to do with long-term trends or tail risk events than with news around a single name.

Barua says such a cost-effective solution has been in the works in the last nine months at IBM. "Market risk is pretty well standardized. The more interesting problem is around stress-testing for liquidity, and how to design a solution that is satisfactory to a broad range of clients requires more conversations," he says. "This is not going to be a panacea so much as step-by-step, starting with rudimentary credit functionality where a hedge fund can gain access to the same coverage a much larger bank might, but with simpler metrics."

Artistic
All of this leads to back to the essential question: What for? The roundtable broadly agrees that regulatory and compliance requirements—and the technology offerings produced to meet them—aren't worth their salt (or cost) if, as the next crisis event unfolds, they haven't left firms with a stronger sense of reality than in the past. With the recent bank run and European troika-led bailout in the Republic of Cyprus, contagion and country risk are just the latest example, says Nysif’s Sayegh.

"[As a portfolio manager] can you afford to wait it out?" he asks. "Those times can be the best time to buy, but what are you selling in return to fund it? Or if you sell, you likewise keep in mind that cash provides a zero gain anyway."

Guardian Life's Abbott calls it the price you sometimes have to pay in a changing environment, where firms have to make a call based on an "artistic assessment" of emerging risks, often on incomplete information about the reality of an asset's exposure. New solutions around credit and liquidity may not set the truth or future in stark relief—remembering the depth and uncertainty of the modeling involved—but as hysteria threatens to descend, they should point a direction.

As Nomura's Patel, who spent most of his career at Lehman Brothers before its collapse in 2008, puts it, "The switch in mindset during an abnormal event is always much harder. Nobody [at Lehman] thought it would happen until the next day—the credit default swap (CDS) spreads were telling the truth, people just didn’t want to believe it. It comes back to bridging that gap."