INsight - Quantifi Newsletter issue 03
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The document discusses the evolving landscape of counterparty credit risk management, highlighting insights from Quantifi's CEO, Rohan Douglas, and industry experts. It addresses the importance of advanced analytics, regulatory compliance, and infrastructure investment for risk management in OTC markets, while noting the challenges faced by financial institutions amid market volatility. Additionally, it emphasizes the role of technology and strategic decision-making in navigating the complexities of credit risk and improving operational efficiency.
INsight - Quantifi Newsletter issue 03
- 1. IN NEWSLETTER ISSUE 03 SIGHT 2011 THE EVOLUTION OF COUNTERPARTY CREDIT RISK: An Insider’s View Also in this issue: Rohan Douglas, CEO, Quantifi talks about release of QX.1 Page 3 Q&A with Olivier Renault, StormHarbour Page 6
- 2. MESSAGE NEWS FROM Client News: THE CEO Varden Pacific Selects Quantifi to Power OTC Trading and Regulatory Compliance “The unique combination of intuitive data management, fast and accurate Even though regulatory uncertainty and market volatility risk analysis, and flexible, detailed continue to dominate the OTC markets, we are seeing reporting gives us the confidence to institutions that are profiting from being able to capture make informed investment decisions opportunities as they arise. This is an environment where an whilst providing the transparency and investment in better analytics and risk management can make a robust infrastructure our investors difference to profitability. In a similar way, we believe a proactive require. Quantifi Risk was deployed in investment in infrastructure to support central clearing and new a matter of days. As it required minimal regulations will make a difference to future profitability. internal infrastructure and resources, we were able to enter the market quickly On the subject of investing in infrastructure - technology is and achieve an immediate return on our playing an increasingly important role for the OTC markets and investment.” - Shawn Stoval, Managing this trend is likely to accelerate with the introduction of central Partner, Varden Pacific clearing. The complexity of the trading, operational, and risk management systems required to support OTC businesses Prosiris Selects Quantifi for Risk have dramatically increased. Comparing state of the art from Management and Reporting ten years ago to state of the art today highlights the challenges “Given the sophistication of our trading of developing systems that not only meet current needs, but strategy, the key factors in selecting also are flexible enough to keep up with future demands. Quantifi Risk are industry leading analytics combined with flexibility and usability. As At a time when the cost of capital is increasing and profitability a recognised leader, Quantifi provides the is uncertain, the accurate and careful management of capital level of accuracy and sophistication we and return on capital becomes essential to a firms survival. As need to trade and effectively manage our the complexity of technology infrastructure increases, cost and risks. By partnering with Quantifi we now project risk dramatically increase. An estimated 50% of large have the opportunity to focus our capital IT projects fail (Harvard Business Review Sep’03). This failure and time on our core business rather than carries both a huge cost risk as well as opportunity risk to spend time and resources developing an businesses that depend on timely delivery of this infrastructure. internal solution.” - Jerry Chang, Chief This shifting dynamic is re-defining the efficient boundary of Financial Officer, Prosiris the buy versus build decision. As IT becomes more strategic, institutions need to carefully evaluate and manage their IT spend and focus on IT that provides a competitive advantage while 2011 Events: outsourcing at a lower cost the infrastructure that does not. Credit Risk USA - New York City, September 15 This month we have some exciting corporate news. I am delighted to welcome Dmitry Pugachevsky, former head of Dmitry Pugachevsky, Director, Research at counterparty credit modelling at JP Morgan, as Research Quantifi, leads post-conference seminar Director. Dmitry is a well-known figure in the industry and his on counterparty credit risk and CVA extensive counterparty credit and broad cross-asset modelling Quantifi Seminar: Counterparty Risk experience is a great addition to our team. Furthermore, our and CVA, What’s New? - New York City, release of QX.1 demonstrates our significant investment in October 18 development and our commitment to ensuring our clients Join Quantifi & PRMIA for an interactive remain competitive by being well-prepared and strategically seminar on counterparty risk and CVA and positioned for future change. hear from experienced practitioners. Risk USA - New York City, November 1 - 2 Quantifi sponsors Risk USA Risk Minds - Geneva, December 6 - 8 Quantifi sponsors RiskMinds, Geneva. ROHAN DOUGLAS, Founder and CEO Visit us on Stand 4 02 | www.quantifisolutions.com
- 3. Rohan Douglas, CEO of Quantifi, talks about the latest version release of its pricing and risk analytics software, Quantifi QX.1 Driven by client needs and transformations in the OTC markets, QX.1 (V10.1) includes a broad range of enhancements across Quantifi’s entire product range including enhanced reporting, data management capabilities and broader asset coverage. What were the key goals for QX.1? needs with our new generation of client plug- A key driver for QX.1 has been the rapidly changing and-play interfaces regulatory and market environment. Our goal is to Leverage Quantifi to support a broader range of provide clients with a smooth transition to central traded asset classes clearing, valuation model changes and future regulatory More easily interface with additional data demands including Basel III. Helping our clients focus vendors with expanded out of the box support on their core business by providing them with tools that Provide on-desk CVA pricing integrated with they can depend on has always been a priority. Another Quantifi’s pricing and structuring solutions key goal for QX.1 has been responding to client demand Implement Basel III compliance with enterprise for broader asset coverage. counterparty risk solutions How does QX.1 support the ongoing OTC market changes? Regulatory and structural changes in the OTC WHATS NEW IN QX.1? markets are having a profound impact on all aspects of technology, research, and operations. QX.1 demonstrates our long history of being able to rapidly evolve ahead of the market and introduces enhancements for FX, FX Forwards, FX innovative new functionality as well as broader asset Options, basis swaps, callable bonds, convertible bonds, FRAs, Swaptions and coverage designed to help clients, including: credit index options Expanded asset coverage matching client demand Significant enhancements to counterparty risk risk management including Basel III management including Basel III compliance compliant capital calculations, stress A unique new plug-and-play interface for client testing, back-testing, enhancements to model integration, product extendibility, and margin period of risk calculations, collateral data integration thresholds by rating, additional calibration Expanded data management capabilities tools and extended product coverage for Additional data vendor interfaces for smooth commodities and inflation integration A redesigned reporting engine with more flexibility, to simplify complex data integration and better reporting, and improved performance data management How will your clients benefit from QX.1? We work hard to make sure our migration process is play client model integration, product smooth and simple. Clients will be able to leverage extendibility, and data integration new features immediately. I would expect key benefits to be: memory hypercube for improved reporting and drill down flexibility, simplified integration Produce more detailed reports with enhanced of external data sources, and improved graphics and more flexible reporting for even the performance for high-volume portfolios largest portfolios Easily customise our solutions to specific www.quantifisolutions.com | 03
- 4. COVER STORY THE EVOLUTION OF COUNTERPARTY CREDIT RISK: An Insider’s View BY DAVID KELLY, Director of Credit, Quantifi a single number that could be used for rudimentary and JON GREGORY, Consultant calculations. In contrast, the more derivatives oriented investment banks calculated reserves by simulating Counterparty credit risk management has been evolving potential future positive exposures of the actual for over a decade from passive risk quantification and positions. The simulation models persevered because reserves to active management and hedging. The term they more precisely valued each unique position and CVA (credit value adjustment) has become well-known directly incorporated credit risk mitigants. and represents a price for counterparty risk. Substantial responsibility is being transferred from credit officers to By 2000, the simulation based CVA and economic CVA traders, groups with the responsibility of pricing capital reserve model was state of the art although and managing all the counterparty risk within an only a few institutions were able to perform exposure organisation. Banks today tend to be distributed along limit checks and calculate pre-deal CVA on a real-time the evolutionary timeline by size and sophistication. basis for new transactions. Institutions had expanded Whilst global banks are focusing more on hedging CVA, portfolio coverage in order to maximise netting and driven by dramatically increased capital requirements diversification benefits. However, the down credit cycle under Basel III, smaller and more regional banks, initiated by the Enron and WorldCom failures, following together with other financial institutions such as asset the wave of consolidation and increased concentration managers are closer to the beginning stages. of risk, forced the large banks to think about new ways to manage credit risk. Reserve model While banks had used CDS as a blunt instrument to Reserve models are essentially insurance policies reduce large exposures, there had been limited effort in against losses due to counterparty defaults. For each actively hedging counterparty credit risk. The need to transaction, the trading desk pays a premium into a increase capacity, as well as changing standards for fair pool from which credit losses are reimbursed. The value accounting (IAS 39 and FAS 157), spawned two premium amount is based on the creditworthiness of significant and mostly independent solutions. The first the counterparty and the future exposure, accounting solution, driven by the front office, involved pricing and for risk mitigants such as netting and collateral hedging counterparty credit risk like other market risks. (margin) agreements and the overall level of portfolio The second solution, basically in response to the first, diversification. Traditional pre-merger banks and introduced active management into the simulation model. their eventual investment banking partners all used reserve models and exposure limits, but the underlying methodologies were very different. Front-office market model An innovation that emerged in the mid to late 90’s was Banks typically converted exposures into so-called incorporating the credit variable into pricing models ‘loan equivalents’ and then priced the credit risk in loan in order to price and hedge counterparty risk at the terms. In the early days, loan equivalents were critical to position level like other market risks. There were simplify a potentially quite complex future exposure into two ways to implement this ‘market model’. The first 04 | www.quantifisolutions.com
- 5. involved valuing the counterparty’s unilateral option to frequency, although ongoing numerical and default. The second used the bilateral right of setoff, technological innovations are collapsing these times. In which simplified the model to risky discounting due to addition, residual correlation risks, including wrong-way the offsetting option to ‘put’ the counterparty’s debt risks, continue to pose a significant challenge. struck at face value against an exposure. Current priorities A few institutions considered transitioning as much Since the onset of the crisis, firms that had a of their credit portfolio as possible into the market comprehensive, integrated approach to credit risk model, using bilateral setoff wherever possible and the management survived and emerged while those that had unilateral option model for the rest. The idea seemed a fragmented approach struggled and failed. This punch reasonable since over 90% of corporate derivatives line and the evolutionary process that helped deliver were vanilla interest rate and cross-currency swaps. it have resulted in a general convergence toward the Aside from the obvious issues, e.g., credit hedge portfolio simulation model with an active management liquidity, the central argument against this methodology component. Several global banks are setting the standard was that it either neglected collateral and netting or for best practice whereas most mid-tier and regional improperly aggregated net exposures. The ultimate banks are still balancing the need to comply with CVA demise of the market model as a scalable solution was accounting requirements with more ambitious plans. that the marginal price under the unilateral model was consistently higher than under the simulation model. Global banks are pushing the evolution in three main areas. First, there is a recognised need to incorporate Another detriment was the viability of having each wrong-way risk. Basically, wrong-way risk is the case where trading desk manage credit risk or be willing to transfer the counterparty’s probability of default increases with its it to a central CVA desk. In addition, systems had to be exposure. Second, recognising collateral risks in terms of substantially upgraded. A central CVA desk proved a liquidity, valuation and delivery is clearly important. Third, more effective solution but raised political challenges capturing as much of the portfolio as possible, including over pricing and P&L. In short, the substantial set of exotics, increases the effectiveness of centralised credit issues with the market model caused firms to revisit pricing and risk management. Since a disproportionate the reserve model. amount of risk may come from products for which they struggle to quantify the CVA (such as credit derivatives), Merger of the reserve and market models many institutions also favour central counterparties. Attempts to move credit risk out of the reserve model and into a market model inspired important Basel III provides more incentive for central innovations in the simulation framework related to active counterparties due to the near zero risk weighting management. Banks had been executing macro or of cleared positions. In addition, the Dodd-Frank overlay CDS hedges, which were effective in reducing legislation in the US and EMIR in the EU mandates capital requirements but ineffective in that the notional clearing as broadly as possible. Other influential amount was based on a statistical estimate of the provisions in Basel III are the additional charges for CVA exposure, not a risk-neutral replication. In addition, that VaR. With the volatility of credit spreads and potential exposure (notional) varied over time. magnitude of CVA VaR, which may double or even triple regulatory capital requirements for counterparty The introduction of contingent credit default swaps risk, banks are incentivised to actively hedge CVA. (CCDS) addressed the varying notional by setting it to the fluctuating value of an underlying derivative Another key recent priority has been the use of bilateral contract. Whilst CCDS are tailor-made to transfer over unilateral CVA. Bilateral counterparty risk is often counterparty risk within a given contract, extending expressed as DVA (debt value adjustment), which them to cover many netted contracts with collateral mirrors CVA. Prior to 2007, financial credit spreads were agreements would be extremely complex, not least extremely low and there was little interest in accounting in terms of the required documentation. For these for DVA. However, the recent severe deterioration of reasons, the CCDS product has not developed strongly all credit spreads, including financials, has incentivised despite the increasing focus on counterparty risk. banks to price DVA in order to offset CVA losses. Although counter-intuitive, since the bank makes money Hedging also involved perturbing the market rates when their own credit spread widens, the use of DVA has used in the simulation and then calculating the become common and generally accepted. portfolio’s CVA sensitivities, which could then be converted to hedge notionals. This helped stabilise These priorities were a direct result of recent events but the CVA charge and reduce economic capital reserves most are not new. Counterparty credit risk remains a very thereby improving incremental pricing. There were complex problem and institutions have had to approach several issues with this approach. Simulation of the it in stages. Current best practice is the result of a long entire portfolio could take hours and re-running it and iterative evolutionary process from which we can for each perturbed input has restricted rebalancing expect another round of innovation. www.quantifisolutions.com | 05
- 6. Q&A FEATURE with Head Olivie of Str r Re uctur nault Storm ing & , Harb Advis our ory, What does StormHarbour do? Over the course of the past 12 months what StormHarbour is an investment banking partnership do you consider to be the most significant focused mainly on fixed income products and with development in the credit markets? particular expertise of complex structured assets: I would say two things: first is the lack of action in securitised products, project finance/infrastructure, primary structured credit markets, particularly in Europe. real estate, and other asset-based finance. We are At the beginning of the year a lot of people thought that active in secondary sales and trading, as well as 2011 would be the year of the re-opening of primary primary markets (raising capital for corporates, banks markets. In fact we saw very little action in public markets or specific infrastructure projects) and advisory. but primary issuance was still dominated by retained The firm was launched in 2009 and we now have securitisations and bilateral funding transactions. approximately 200 people across 8 global offices. The other key theme of the past 12 months is the volatility What is your role within the company? in secondary markets with the end of the big rally which I’m responsible for the Structuring & Advisory team in started in 2009 followed by a spectacular sell-off. London. We focus primarily on financial institutions and provide advisory services as well as assistance in the What key challenges and/or opportunities does structuring and placement of new transactions. To give the current environment bring to your business you a few examples, we have advised one of the leading and how do you intend to manage them? US private equity firms on regulatory capital issues The challenge is the uncertainty on European revolving around its bid to take over a European bank. We sovereign risk and its impact on credit and other have also been mandated to provide advisory (valuations, markets. While a bit of volatility is good to spur an stress testing, restructuring proposals) on about $20bn active trading market, too much uncertainty leads of assets for half a dozen institutions over the past year. to low volumes of flow trades and a moribund Furthermore, we have been active in structuring funding primary market. and regulatory capital release transactions. Regarding opportunities, we expect a wave of asset disposals from banks and public bodies as well as a 06 | www.quantifisolutions.com
- 7. A Quantifi Client significant pickup in M&A transactions in the financial Sometimes flow trading is the main revenue generator sector. StormHarbour is very well positioned to for the firm because clients are particularly active and assist governments, public sector entities and banks want to either liquidate positions or acquire risk. More because we have a combination of skills in financial recently the volatility has frozen a lot of the flow activity assets, real estate as well as infrastructure finance, and it was nice to see other areas of the firm, primarily which will be the bulk of the sales to come. advisory and client capital raisings take over. We are having a very good year so far. That differentiates us Looking ahead, what market developments significantly from small advisory shops or pure brokers do you anticipate? who are relying only on one business line. That is also Regulatory pressures are going to penalise banks reflected in our advice: because we have both advisory significantly in particular for structured credit. and execution capabilities, we can recommend solutions Furthermore their difficulties in securing cheap long that are really actionable, not purely theoretical. term funding will lead banks to retreat again from commercial real estate, long term corporate lending “ While a bit of volatility is good and infrastructure financing. This is a great opportunity to spur an active trading market, for us to get real money clients involved in these markets and arrange transactions that bring alternative funding too much uncertainty leads to providers to banks. We also expect to increase our low volumes of flow trades and a market share in secondary structured credit trading moribund primary market.” as banks progressively step back due to increased capital requirements. What differentiates us from banks is mostly the fact that we work for clients and not for our own book. So How does StormHarbour differentiate itself our advice is not tainted by whatever legacy position from its competitors? we may have, and because we act as arranger and Diversification is key. StormHarbour has geographical placement agent on structured trades, rather than as diversification – we are active in the US, Europe and counterparty, the real economics of the deals are much Asia – and also product and services diversification. more transparent to our clients. www.quantifisolutions.com | 07
- 8. Whitepapers Videos OIS AND CSA DISCOUNTING TRENDS IN COUNTERPARTY A new generation of interest rate modelling based on dual RISK MANAGEMENT curve pricing and integrated CVA is evolving WORKFLOWS: CHALLENGES IN IMPLEMENTING David Kelly, Director of Credit Products, explores the challenges and trends in A COUNTERPARTY RISK counterparty risk management by tracing MANAGEMENT PROCESS typical workflows within a global bank Key data and technology challenges before and after CVA desks, and how Current trends in best practices increased clearing affects these workflows. EVOLUTION OF COUNTERPARTY CREDIT RISK THE UNCLEARED SIDE Explores practical implementation issues and how OF DERIVATIVES approaches have converged An insider’s view from the major banks that have David Kelly, Director of Credit Products, influenced this market talks to Greg Crawford, Editor, TABB Forum. Request a copy: View videos enquire@quantifisolutions.com www.quantifisolutions.com/videos.aspx New Hire DMITRY PUGACHEVSKY, DIRECTOR, RESEARCH Dmitry joined Quantifi in September 2011 and is responsible for managing Quantifi’s global research efforts. Before joining Quantifi, Dmitry was Head of Counterparty Credit Modelling at JP Morgan. Before starting at JP Morgan in 2008 Dmitry was Global Head of Credit Analytics at Bear Stearns for seven years. Prior to that, he worked for eight years within the analytics groups of Bankers Trust and Deutsche Bank. ABOUT QUANTIFI Quantifi is a leading provider of analytics, trading and risk management software for the Global Capital Markets. Our suite of integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposures and respond more effectively to changing market conditions. Founded in 2002, Quantifi is trusted by the world’s most sophisticated financial institutions including five of the six largest global banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and other financial institutions across 15 countries. Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-market with intuitive, award-winning solutions. enquire@quantifisolutions.com | www.quantifisolutions.com Europe: +44 (0) 20 7397 8788 North America: +1 (212) 784 6815 Asia Pacific: +61 (02) 9221 0133 Follow us on: © Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Toolkit, Quantifi Counterparty Risk, Quantifi CVA are trademarks of Quantifi Inc.