CutterAdvantEdge

Issue 64, January 2009

Riding A Tiger: When Risk Becomes Reality

“It was like riding a tiger, not knowing how to get off without being eaten.” So said B. Ramalinga Raju, Chairman of Satyam Computer Services Ltd., in disclosing the scam where Satyam had manipulated its financials including overstating profits, understating liabilities and creating a bogus cash balance of $1 billion.

There were earlier warnings of financial shenanigans with disclosure of a dubious insider real estate deal. This was generally ignored by investors, and stunned portfolio managers saw Satyam shares decline 78% in one day on the Bombay Stock Exchange. How could auditors and regulators have missed such a comprehensive fraud? Where were the financial analysts whose job it is to “dig into and understand the financials?”

Proper risk management means not being surprised. Unfortunately, 2008 was full of surprises. The subprime mortgage crisis and resultant meltdown of markets, the Madoff fraud, counterparty failures, bank failures, no liquidity, information quality lapses, and operational risk all plagued the investment management industry. Among the asset management firms of the CutterResearch consortia, 38% felt in 2008 they could no longer accurately calculate risk for their investment strategies or the asset classes they invested in, and almost 90% said their existing risk management had to improve.

Asset management firms want 2009 to be, more than anything else, the year without surprises, so they’re making significant investments in their risk infrastructure and developing risk frameworks for market, credit, and operational risk. Member firms are also seeing data management and derivatives through the lens of risk management, and they are changing approaches accordingly. We reveal the trends we discovered here.

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Market, Credit, and Operational Risk Management

The broadest trend among our member firms is a movement toward front-to-back, enterprise-wide risk management. They are increasingly recognizing that a silo approach is less effective in understanding the true risk of a firm or portfolio, and more costly because it requires separate teams with separate systems and data. As a result, they are merging their credit risk and market risk management, and combining the risk management previously separated by asset class. They are moving toward a common platform and practice that fosters sharing of results and captures a more accurate picture of the firm’s total risk by using consistent data and assumptions for calculations and analytics. John Clark, Cutter Associates President and CEO, observes, “Many firms today are seeking a more robust ‘top of house’ view of their risk. In addition to market, credit, and operational risk, this view includes a more holistic picture of the enterprise, identifying areas of potential concern.” In other clear trends, firms are looking for systems that provide intra-day risk functionality and cover a broad range of asset classes including commodities, private equities, and derivatives. Member firms also indicated a strong preference for solutions that incorporate counterparty risk to assess the potential of corporate bankruptcies, defaults, and risk of defaults. A recent CutterBenchmarking survey found that one third of member firms are currently automating their manual risk management processes, and most of the remaining firms plan to automate these processes in the next year. And as firms try to reduce the cost and volume of incoming data, they are focusing on gathering data that directly fuels their risk management engines.

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For operational risk, 2008 was certainly a grim year. Investment scandals and questionable investment practices became front page fodder and sent investment firms scrambling to assess their internal practices and procedures to avoid being tomorrow’s front page news. Firms are now taking operational risk seriously, launching operational risk management (ORM) programs, restructuring their organizations to incorporate the role of a Chief Risk Officer, and adopting tighter risk management structures.

If one thing is certain for 2009, it is that new regulations are coming to the investment industry. Clark says, “There is little doubt that we will see material changes in regulation and reform. Firms will need to have the proper infrastructure in place to address these changes quickly and efficiently.” When the new regulations come, the firms now acting decisively could find themselves well positioned to accommodate regulatory changes.

As we move forward into 2009, the turbulence in global financial markets is expected to continue. Maneuvering successfully through the financial turbulence will require financial firms to keep market and credit risk practices and systems at center stage.

Data Management Solutions

In 2009, asset management firms will continue cutting back on large data programs to focus on a smaller quantity of higher quality data. They are mainly concentrating on data that directly supports their risk management programs, because they clearly see data as the real core of risk management. Clark says, “Everything starts with the data. Once a firm can rely on the availability and quality of data, applying business rules becomes a much easier task. It also results in senior staff spending more time focusing on high value functions.” Cutter’s research shows that vendors of data warehouse and reference data management products continue to improve their support of complex assets and exposure in several ways: their products are covering a broader range of security data, they include new tools that firms can use to manage metadata and extend their own data models, and the standard data models have been improved to track hierarchies of issues, issuers, and other business entities to support risk management.

Vendors are updating online tools to support a new group of users-non-technical, business-oriented users. They are also streamlining workflows to support quality assessment of incoming data, and they are improving productivity for data quality processes. Member firms are looking to centralize their data and data management functions to enable more intelligent and efficient data distribution to traders and risk management entities. Cutter Associates expects that vendors will soon begin to improve data distribution functionality, through internal development or through partnerships with data distribution specialists.

Derivatives Systems

Buy-side firms are acutely aware that they need ways to better manage derivatives, including improved derivatives valuation and more revealing views into derivatives exposure (transparency). Until recently, it was mostly the sell side that benefited from systems with automated derivatives functionality. Alternatively, the buy side has improvised with spreadsheets, databases, and other workarounds. Now vendors are taking the systems they built for the sell side and re-engineering them with buy-side requirements such as trade allocation, pre-trade compliance, cash balance management, and portfolio-level positions.

Although the new systems, owing to their sell-side pedigree, tend to be expensive, product-specific (for example just credit derivatives or just equity derivatives), and very complex to implement, member firms with substantial derivatives positions are moving forward with implementations of front-to-back derivative systems. Firms like these have kept CutterConsulting busy recently with derivative systems strategies, searches, and implementations. Some vendors are trying to address the need for speedy deployment by making their products available on an ASP basis.

From a market perspective, we expect to see sustained efforts to reduce operational risk and enhance operational efficiencies surrounding derivatives. Current initiatives include automation of novation workflows, possibly the creation of an exchange-like execution and central clearinghouse for credit default swaps, and using a “tear-ups” process to cancel derivative trades that have offsetting economics. Member firms are focusing their efforts on ensuring that OTC derivatives are properly valued and exposures are fully understood.

We are seeing unprecedented cooperation among industry participants to find workable solutions for managing derivatives, which makes us optimistic that we will continue to see progress toward automation and standards for meeting the needs of asset managers.


Upcoming research events for 2009 will include reviews of Risk Management Systems and Processes, Investment Administration Outsourcing, Alternative Investment Systems, and Fixed Income Portfolio Management Systems.