Improving braking power and speed

The global financial crisis exposed gaps in regulation and risk management. Now new rules have been designed aimed at preventing the same mistakes from happening again. Dan Barnes assesses the impact of advanced technology on managing the risks

Imagine a room with a thousand casino tables and just two players on each table. This was the global over-the-counter (OTC) derivatives market five years ago.

A derivative is a contract that says, under certain conditions, one signatory has to pay the other. Many derivatives could be described as complicated betting slips.

In the OTC market, every bet was placed between two firms, with no security of payment beyond the collateral they placed on the table as an ante. There was no oversight of collateral quality or how many other tables a bank was playing on, or if the ante was covering bets on several tables or even if a player had sold his betting slip to someone else.

When it turned out that a lot of the collateral used as ante was bad mortgage debt, it caused massive problems. On September 15, 2008 one of the big US banks, Lehman Brothers, went bust. It was not going to pay out on its bets, so the other players worried who else might go bust.

The biggest insurance firm in the world, AIG, had bet the wrong way on lots of bad debt and, using the poker analogy, could not stump up the ante to keep playing with big brokers. US taxpayers’ money was used to pay the ante and AIG was effectively nationalised.

Not only were a huge number of firms using bad debt as collateral, many were relying on borrowing funds, called “using leverage” in banking, to keep playing. There was a catastrophic domino effect.

No one could see how bad the problem might get. Credit rating agencies had rated bad collateral as “AAA”, so they were not trusted and credit worthiness was impossible to judge. Lending and spending froze, except for the taxpayers who coughed up for the bad debts that the banks were gambling with and paid to keep the markets moving.

Fast forward to 2013 – and every “casino table” now has a third person sitting at it, called the central counterparty (CCP), who takes the ante, checks its value, then holds on to it so, if one player goes bust, the other still gets paid. If someone sells their hand on to someone else, the market supervisor records it, tracking who holds each bet.

Rules are being put in place to stop European banks from gambling with the savings of everyday people; US banks are being banned from gambling. Players are not rewarded with big bonuses for taking big risks.

Collectively, these measures should, in theory, protect the man on the street from having to cover such costs again. So, in the new environment, there will still be bankruptcies, but they will not cascade into the rest of the market.

Firms are under no illusions that getting risk-management technology right is just the starting point

According to Rodrigo Buenaventura, head of the markets division at the European Securities and Markets Authority (ESMA), a pan-European regulator designed to connect the dots for national regulators dealing with international firms, the main weaknesses have been addressed.

“In Europe, we have introduced credit rating agency supervision for the first time,” he says. “There was no obligation to report OTC derivatives transactions on a daily basis which we now have – trades now have to be reported to a repository. There was a problem with firms being over-leveraged [with too much debt] and not using enough collateral as security in case something went wrong, which new regulations will address.”

The G20 countries have all committed to making markets safer and the US is implementing similar market rules based on the Dodd-Frank Act, passed in 2010.

Craig Lewis, chief economist and director of the RiskFin Division at US market regulator, the Securities and Exchanges Commission (SEC), says: “I think the Dodd-Frank Act allows regulators to track and monitor the build-up of risky positions as they develop. If regulators desire to monitor that risk, they will now be able to by tracking who has large positions.”

Both regulators note that, if these rules had been in place in those crisis conditions of 2008, a lot of the problems would have been mitigated.

“If the regulatory response had been in place before the crisis, it would possibly have changed its intensity; it might even have averted it,” says Mr Buenaventura.

However, there are concerns that the new rules are creating new risks. For example, there are only a few CCPs that are collectively used by the industry to hold collateral and some market participants are asking whether taxpayers’ money would have to be used if one of them failed.

Anthony Belchambers, chief executive of the Futures and Options Association, an industry body that engages in lobbying and liaison with regulators and government bodies, says: “Traditionally the view was that the best way of managing risk was to diversify it. With CCPs, there is a reappraisal that suggests concentration may be a good thing. I don’t know if that shift poses less or more risk to the financial system, but I think we need to justify the view that risk concentration, in certain areas, is a good thing.”

Steffen Kern, head of the Economic Research and Financial Stability Unit at ESMA, is positive about the new regime as it removes a significant amount of uncertainty that had existed under the previous arrangements.

“CCPs will mitigate risks we saw pre-crisis,” he says. “The new risks that may arise, such as concentration risk, can be controlled more easily than the diffuse and obscurely linked risks, which are spread over the entire system in an OTC world. Getting better control of the system is the outstanding benefit that we have from using central counterparties.”

There are many examples of risk management failure at financial services firms post-crisis: the loss of US$440 million in 45 minutes by broker Knight Capital on August 1, 2012 due to an automated trading system; the $100-million fraud-based bankruptcy of broker Peregrine Financial on July 10, 2012; the $40-billion bankruptcy of broker MF Global on October 31, 2011 in which $1.6 billion of client money went wandering off.

Technology can help manage risk. By putting all the data from a firm’s financial positions into a single system and then checking how the movement of other factors (interest rates, market movements, exchange rates) might affect those positions, financial services firms can identify potential problems before they happen.

However, the advances in technology, which enable the processing of risk calculations at higher speeds than ever before, also allow firms to take risks at higher speeds. This is like improving both the braking power and the top speed of a car, delivering no net improvement in safety, says Cubillas Ding, research director of the Securities and Investments Group at analyst firm Celent.

“In our experience, firms are under no illusions that getting risk-management technology right is just the starting point for improving risk management,” he says. “In the last crisis, some firms had their vision hampered due to lagging risk technology. But other firms ignored the information because of trade-offs within the firm; their issues were more about the culture and organisational dynamics within the company.”

Mr Lewis concurs, noting that what happened within individual firms was not the challenge in the crisis: “We didn’t have transparency into the OTC derivatives market. I would argue that the big problem wasn’t technology, but the fact that the market operated in an opaque manner.”

Individual firms have to take risks and, by the nature of the business, they fail on occasion. By placing a structure around trading firms, this will contain the effect of failure, which regulators believe can make the markets safer. But they are not in a position to rest on their laurels.

“Improvements in technology have led to a system of electronic trading that is prone to a number of risks because it is new, it is growing fast and it is complex,” Mr Kern concludes. “That is a perfect combination of factors to create a risk to systemic stability.”