Cash & Liquidity ManagementInvestment & FundingCapital MarketsRiding Out the Risks of the Credit Crunch

Riding Out the Risks of the Credit Crunch

The credit crunch saga has market participants worldwide paying more attention than ever to the astute management of their risk exposures. No investment, trading counterparty or client is completely pristine and free of risk. This sentiment has permeated to the short-term cash markets as well, with treasury desks acutely aware that the reluctance of certain banks to lend freely in the inter-bank market is creating caution and apprehension among the most seasoned professionals. Risk-taking brings profit, but good risk management allow firms to keep it.

For example, the growing over-the-counter (OTC) derivatives market involves lots of risk and provides handsome rewards for those that navigate well. The three foremost derivatives classes – interest rate swaps, equity and credit derivatives – have soared to €327 trillion outstanding according to International Swaps and Derivatives Association (ISDA) figures. However, this meteoric growth has not been matched by adequate attention to operational risks. In fact, the rise in OTC derivatives trading and the lack of post-trade standardisation and automation is a cause for serious concern. Today, firms grapple with piles of unprocessed transactions, leading to severe breaks in reconciliation, and problems with collateral and exposure management further downstream.

Adding to this operational conundrum is the November 2007 Basel II deadline – guidelines that set out to segregate operational risk from credit risk. As from 1 November, firms will be required by law to have rigorous risk and capital management measures in place, designed to ensure that banks hold capital reserves commensurate to the risk exposures arising from their lending and investment practices. With firms needing to keep more reserves on their books, cash could become even scarcer. Consequently, firms could well start to look at alternative ways of collateralising exposures with securities.

Exposure Management With Control

Solutions do exist for firms to calculate their derivatives portfolio exposures and to confirm transactions. For example, the Depository Trust & Clearing Corporation (DTCC) offers Deriv/SERV – an OTC derivatives matching and confirmation service for credit derivatives, designed to streamline the costly and risky business of manual trade confirmations. In Europe, organisations like ISDA, together with SWIFT, Euroclear Bank and the Collateral Framework Group have been active in looking at various parts of the OTC derivatives processing chain to improve key operational aspects. And now these organisations are co-ordinating their findings and pushing standardisation and automation, so badly needed in this market.

Although cash is most often used to cover exposures arising from OTC derivatives, securities are increasingly used as collateral. As a consequence, securities pricing has been placed firmly under the spotlight. Like with other forms of collateral transactions, such as repos and securities loans, the quality of the data used to value OTC derivative portfolios exposures and the collateral covering them is highly dependant on the reliability, accuracy and age of the prices used. Getting this right is key to mitigating exposure-reconciliation disputes and providing a true sense of the risks and exposures to manage. Obviously, consulting and cross-checking multiple data sources is an imperative, but here again is where automation and standardisation can play an important role in providing all relevant parties with fresh and transparent valuations. A service provider that has a deep and frequently refreshed pool of securities and historical trade data for the underlying collateral is well suited for the task.

International central securities depositories have not typically been involved in the processing of OTC derivatives. But there is no reason why the automated streams using standardised communication and documentation in post-trade processing for bonds and equities cannot be applied to OTC derivatives portfolio reconciliation and exposure management. Understanding the operational risks that firms run by operating in sub-optimal conditions is the critical starting point. Granted, derivatives-transaction processing follows a different set of rules and practices than fixed income and equities, but there is definitely scope for OTC derivatives processing to eliminate operational risks associated with manual intervention.

Deriv/SERV is testament to the growing realisation that uniform documentation, standards and automation are critical to the continued growth of OTC derivatives. The DTCC has been responsive in meeting users’ demands, ensuring that accepted market standards are applied uniformly through its highly transparent platform. Yet, this is only one step in the risk-management cycle. Other solutions let both counterparties to an OTC derivatives deal match trades, reconcile portfolio discrepancies and ultimately collateralise the underlying exposures using a neutral triparty agent.

Today’s changing market dynamics and the vast sums at stake have rocked the market into greater risk awareness. And as the market knows only too well, dynamics that are not managed can entail untold financial risks. Those that try to battle on with bilateral, non-automated methods to assess exposures and administer corrective actions are operating with distinct competitive disadvantages.

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