Emerging from the financial crisis: A new era for CCP risk management

July 2010

......................................................... 6 Conclusion ................................................. 1 Risk management lessons learnt ..........................................................Contents Foreward ........................................... 3 Laying the foundations for growth ......................................................... 9 Emerging from the financial crisis: A new era for CCP risk management .................. 5 Key characteristics of an effective risk management technology solution ....................................................................................... 2 Enhanced role for CCPs in achieving market efficiency and stability ................

CCPs are being propelled onto the world stage because of the unique role they can play in significantly reducing risk and enhancing market efficiency and stability. Sincerely. This will enable them to determine what technological and operational infrastructure changes are needed in order to support business expansion. the ability to measure risk in real time. and reduce systemic risk in global financial markets. comprehensive stress-testing and robust default procedures. it is now more critical than ever to examine how risk is measured and managed across their organisations. This paper will identify a number of characteristics for an effective risk management technology solution that will provide a platform for growth. information technology. The regulatory proposals intend to capitalise on a CCP’s ability to provide improved transparency. as well as expand their product range and geographical reach. A risk culture needs to be established at board level and embedded throughout the organisation and its operations with the appropriate specification of risk appetite. highly responsive.Foreward Dear Colleague. While there are signs of a cultural shift in the way organisations perceive risk and a growing recognition that risk is no longer the concern of just the chief risk officer and in fact needs to be managed holistically across the organisation. reporting and processes. This will enable the CCP to be flexible. Andrew Wood Chief Executive Officer Razor Risk Technologies Emerging from the financial crisis: A new era for CCP risk management 1 . the most important characteristic should be a single integrated risk platform that will allow the CCP to aggregate and monitor total exposures across all exchanges and markets. much work remains to be done. We trust that these insights will help CCPs gain a competitive advantage amidst changed market and regulatory conditions. Proposals by international policy makers to mandate CCP clearing for over-the-counter (OTC) derivatives have created growth opportunities for CCPs to increase volumes. For CCPs that are planning to pursue growth. and ultimately succeed in a new era of risk management. a broad range of risk methodologies. From our experience. infrastructure. The best risk solutions will also comprise an adaptable architecture. forecasting methodologies. a unique window of opportunity has been opened for central counterparty (CCP) clearing organisations. and to scale to keep pace with product innovation and increased volumes. centralised collateral management and increased financial transaction efficiencies. As the global financial community and regulators seek to implement solutions to prevent future market dislocations. The recent disruptions to global financial markets and the resultant economic downturn have underscored the vital role of risk management in avoiding systemic market failures. with the ultimate objective to minimise and manage counterparty risk.

maintaining appropriate levels of liquidity. but also prevented institutions from realistically assessing risk. as they recognise that the way their organisations understand. In addition. such as: integrating transactions across financial institutions so that everything is in the risk system. infrastructure. recent events have shown risk measurement and control across the global financial community must take a giant leap forward. measure and manage risk will help set them apart. organisations need to move beyond applying tactical fixes to address structural and operational shortcomings in isolation. and therefore did not practice the required measurement and control. and there was also an absence of appropriate stress-testing to help institutions identify the consequences of unique market circumstances. This lack of complete and timely risk management information not only contributed to market dislocations. reacting swiftly to potentially adverse or deteriorating positions and minimising losses in a volatile and illiquid market. acted as a major impediment to institutions aggregating and monitoring their total exposures across the entire organisation. There needs to be a fundamental cultural shift towards viewing risk as the responsibility of the entire organisation.Risk management lessons learnt The credit crisis and the collapse of several banking institutions have highlighted deficiencies in the understanding of ‘risk’ and weaknesses in many of the current approaches to risk management and the technology solutions used to measure and control risk. after revenue and profit. forecasting methodologies. revising risk assessment methodologies to incorporate evaluation of tail risk from unlikely events. and linking remuneration to responsible risk management. The separation of market risk and credit risk into silos. Risk is an inherent and necessary component of free markets. Fundamentally. after revenue and profit. coupled with disparate and fragmented internal risk systems. The lack of complete and timely risk management information not only contributed to market dislocations. information technology. A growing number of organisations are taking important steps towards better risk management. but also prevented institutions from realistically assessing their risk. rather than proactive and forward-looking. there was an over-reliance on quantitative measurement tools without a complete understanding of their limitations and assumptions. reporting and processes embedded throughout the institution and its operations. While these changes show risk is starting to be given the priority it warrants. This holistic approach to risk management will see a risk culture established at board level and ensure the appropriate specification of risk appetite. a number of organisations failed to have the necessary ‘big picture’ view of risk. While this is encouraging. strengthening liquidity risk management. appointing external risk managers to report on risk management systems. There needs to be a fundamental cultural shift towards viewing risk as the responsibility of the entire organisation. risk management was generally retrospective. Emerging from the financial crisis: A new era for CCP risk management 2 . concerns for many chief executive officers. It is now one of the top three Risk is now one of the top three concerns for many CEOs.

If achieved. centralised collateral management and increased financial transaction efficiencies. this will assist to mitigate global systemic risk. However. with the ultimate objective to minimise and better manage counterparty risk. While there are many financial sectors under consideration. Arguably. While regulatory proposals are still in flux across many regions (see Key Regulations sidebar on page 4). This has driven regulatory proposals to capitalise on a CCP’s ability to provide improved transparency. Growth opportunities currently stem from increased volumes as well as expanding product range and geographical reach in the OTC derivatives markets. transparent and centralised collateralisation for many OTC derivatives deals played a prominent role in the recent credit crisis. it is likely CCPs will be involved in clearing the majority of trading instruments. the lack of uniform. CCPs may choose to expand their product range or reach through a partnership model. It is likely CCPs may one day be involved in a greater majority of all transactions. acquisition. Emerging from the financial crisis: A new era for CCP risk management 3 . the capture of increased market share or organic growth. new market conditions have created a number of opportunities and challenges for CCPs.Enhanced role for CCPs in achieving market efficiency and stability In addition to changes at an institutional level. international regulators and policy makers are also looking for solutions to minimise future market dislocations. a significant development is international proposals to mandate CCP clearing for OTC derivatives.

The new rules. House Committee (US) In December 2009. the second provides a set of considerations for trade repositories in OTC derivatives markets. The communication outlined a series of policy actions the EC intends to take to address the problems of OTC derivatives markets. This review of the 2004 recommendations was fast tracked and two consultative documents aimed at strengthening the OTC derivatives markets were released in May 2010. The changes will also extend cash flow projection requirements of ADIs to 12 months. interoperability. strengthen existing APRA stress-testing minimums. It was developed by the Basel Committee on Banking Supervision (BCBS). Swap dealers and major market participants will have to adhere to capital and margin requirements. Many provisions in Title VII of the Act will be detailed in the ensuing regulatory rulemaking process by the US Commodities Futures Trading Commission (CFCT) and the US Securities Exchange Commission (SEC). the US House of Representatives passed a plan that included the introduction of electronic trading platforms and central counterparties. a ban on proprietary trading by banks and creation of a new consumer financial protection bureau to oversee mortgage and credit-card lenders. following the Turner Review. The transaction and pricing data for both cleared and noncleared swaps will be reported to a central repository. and demand that liquid assets be self-sufficient and adequate. European Commission The European Commission (EC) adopted a communication on “Ensuring efficient safe and sound derivatives markets – future policy actions” on 20th October 2009. In June 2010. in order to reduce systemic risk and increase transparency. Feedback on the consultative documents will be incorporated in the general review of the international standards for financial market infrastructures that was launched by CPSS. with the goal of promoting a more resilient banking sector. the UK Financial Services Authority (FSA) issued its rules on the liquidity requirements expected of organisations. This will improve the resilience of authorised deposittaking institutions (ADIs) to liquidity risk and improve the regulator’s ability to assess and monitor its liquidity risk profiles. In July 2009. with the ability to access data at short notice and at times of stress. The Act includes new oversight of the OTC derivatives market.IOSCO in February 2010. designed to create greater financial stability. Qualitative aspects of this new regulatory regime have been in operation since December 2009. call for more frequent and meaningful reporting. APRA The Australian Prudential Regulation Authority (APRA) is set to strengthen its Prudential Standard APS 210 Liquidity (APS 210) to meet the qualitative requirements issued by BCBS in September 2008. APRA will issue new standards and reporting forms on liquidity requirements by ADIs. and the reporting obligation and requirements for trade repositories. The strengthening of a counterparty’s capital requirements under Basel II is expected to increase the incentives to move OTC derivatives exposures to CCPs and exchanges. the BCBS approved for consultation a package of proposals to strengthen global capital and liquidity regulations. These initiatives are in line with the G20 agreement signed in September 2009 stipulating that all standardised derivatives should be centrally cleared and reported to trade repositories by the end of 2012 at the latest and that non-centrally cleared contracts should be subject to higher capital requirements. CPSS-IOSCO The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organisation of Securities (IOSCO) 2004 recommendations aimed to set out comprehensive international standards for risk management for CCPs. Basel II/ Basel III Basel II is made up of a number of Accords designed to set international standards and best practice to define minimum capital requirements of international banks. requirements for central counterparties. These rules narrow the definition of liquid assets.Key regulations The following is a summary of some of the key regulatory changes that are shifting the landscape in which CCPs now operate. and standardise the reporting framework for collecting regular liquidity data. definitions and studies are generally required to be completed within 360 days following enactment. with an exemption for foreign exchange swaps and forwards. repos and security financing activities. enhance systems and control requirements. The first document provides guidance on how the 2004 recommendations should be applied to CCPs handling OTC derivatives. the DoddFrank Wall Street Reform and Consumer Protection Act. The derivatives legislation set forth in Title VII of the Act includes a mandatory clearing requirement for the majority of OTC derivative transactions. In December 2009. They are designed to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives. the EC published a consultation paper on derivatives and market infrastructures that details how to implement some of the actions outlined in October 2009: clearing and risk mitigation of OTC derivatives. CPSS-IOSCO announced a review of the 2004 recommendations to offer more guidance to CCPs handling OTC derivatives. Emerging from the financial crisis: A new era for CCP risk management 4 . was passed by US Congress on 15th July 2010 and signed into law on 21st July 2010. The consultation is the final step before the EC submits legislative proposals in September 2010. The final version of the financial reform bill. These proposals were endorsed in 2009 by the Financial Stability Board and the G20 leaders at the Pittsburgh Summit. FSA In October 2009.

It is vital that a CCP’s business has in place a robust and flexible risk management technology framework to allow it to adapt quickly.whilst continuing to lower transaction costs. membership. This will enable CCPs to determine what technological and operational infrastructure changes are needed to support business expansion. Leading CCPs will be able to handle higher volumes at greater speeds. product range. and will become more so in the face of increased competition. stakeholder confidence. CCPs will require an ability to handle higher volumes at greater speeds. and conduct initial and variation margin calculations in order for clearing houses and their members to effectively manage counterparty risk. and appropriately handle the complexity of new products. guarantee. For CCPs looking to drive revenue and growth. a key component of effective risk management is the ability to provide accurate and timely risk analysis to swiftly calculate variation margins and provide competitive pricing. carry out real-time risk pricing and stress-testing. mean that risk management technology is going to be of particular importance to success in this new market situation. In addition.Laying the foundations for growth While every CCP has its own unique features regarding risk mitigation. while continuing to lower transaction costs. The very nature of a CCP’s risk mitigation role. This will ultimately increase Emerging from the financial crisis: A new era for CCP risk management 5 . all while minimising risk to the clearing house. insolvency rules and default management practices. coupled with the highly administrative nature of its clearing services. These may be based on costs. navigate the interoperability and jurisdictional challenges of new geographic regions. products. time to market remains extremely important. its members and markets. CCPs will need to clearly define their points of difference if they are to succeed in the new competitive landscape. In this changing and challenging environment. Moreover. this is a critical time to examine their strategic risk management architecture and core technology systems.. or services. An ability to demonstrate effective and robust risk management will allay concerns surrounding the shift of risk concentration from banks and dealers to CCPs. CCPs need to look at their current risk architecture to assess their ability to keep pace with product innovation to easily add new products. it is vital that a CCP’s business has in place a robust and flexible risk management technology framework to allow it to adapt quickly..

implementation and ongoing support advantages. or sectors. product range. which efficiently organises all risk valuations over a network of servers. The lack of data replication and duplication of integration inherent in a single system with a modern. 2. in this new risk management environment. with no modification of the code required. the graphical user interface and the services. guarantee. enables a CCP to calculate its total exposure and aggregate and monitor client positions across exchanges and clearing houses. the CCP can provide comprehensive collateral management and conduct appropriate modeling and analytics to fine-tune initial and variation margin calculations for specific members. A recommended design format is ‘metadata’. which can assist CCPs to adapt quickly to legislative changes as they arise. pricing algorithms and risk analytics relevant to all required markets. Each CCP has unique features regarding risk mitigation. The architecture and data framework of an effective single integrated risk platform will ensure that a CCP’s product innovation can keep pace with risk technology and analytics. as well as other market pressures. will provide the adaptability required to compete successfully as a CCP. regions. which provides the adaptability to fast track implementation and provide the CCP with a more functional end solution. A single integrated high performance risk platform to allow the CCP to aggregate and monitor total exposures across all exchanges for all products Previously. Such architecture offers the accessibility and interoperability required to simplify any complex issues arising from integration with other systems. market and simulation modules. The addition of new functionality is also made easy.Key characteristics of an effective risk management technology solution Outlined below are seven main characteristics of an effective risk management technology system. the architecture must also scale to increase core density per server in order to achieve the 1. Such models have the flexibility to add. An adaptable architecture to enable the CCP to respond to business. The right architecture should also provide a balanced. with minimal system redevelopment required. with all transactions on one system. Through the one platform. A successful CCP must have both. It allows these exposures to be updated in real time as and when required. scalable and distributed architecture also provides significant performance. Emerging from the financial crisis: A new era for CCP risk management 6 . In addition to providing scalability across servers. Moreover. insolvency rules and default management practices. modular and distributed processing capability. edit or delete data by simply refining the metadata. A single integrated risk platform. and is based on open standards. A CCP needs to have the adaptability to easily add new products. some organisations compromised between speed-to-market and an enterprisewide view of risk. this consolidated view enables a CCP to flexibly measure concentration points across any number of factors such as markets. membership. These should comprise user-defined data types and plug-in support for pricing. such as grid computing. An adaptable architecture should fully utilise commodity hardware to enable the rapid processing of intensive scenario and stresstesting simulations. these changes are then available in the database. This delivers high performance and scalability at a fraction of the cost of alternative technologies. market and regulatory changes A modern and scalable architecture that is aligned to service-oriented architecture principles. Therefore. an integral part of the architecture of an effective risk management technology solution should be the capability to support customisations and configurations in order to fully represent the individual characteristics of a CCP.

The CCP must have the capability to easily add new risk methodologies or to assign specific existing methodologies to meet certain tasks.optimal parallel processing power and enable the CCP to meet any existing and future volume and performance requirements. Too often. CCPs will be able to handle the speed and complexity of risk analytics calculations required for high-volume high-frequency standardised products. institutions have compromised between speed and accuracy of calculations. A distributed computing architecture will provide the computational power to support the efficient intra-day or real-time processing of businessas-usual activity for the CCP. However. allowing for dynamic changes in the underlying portfolio holdings. This greatly reduces risk exposure to relevant members. Multiple risk methodologies. including Value at Risk (VaR). the ‘relevant time’ – needs to be as quick as possible. utilised in the correct manner to achieve accurate and more relevant modelling A best practice risk management technology solution must support a broad range of risk methodologies to provide a more balanced guide. The use of a range of risk measures enables CCPs to measure the risk of default across all or single exchanges. 3. Measure risk in real time so the CCP can quickly resolve outstanding positions in stressed and volatile conditions In the past. inaccuracies result from assumptions or a failure to incorporate real-world risks or adequate stress-testing. In addition. a CCP’s risk management technology solution needs to be able to go beyond point in time and incorporate a forward looking calculation over a multiperiod basis. The time it takes to convert data into interpretable and relevant information that can be used to make decisions – that is. For many instruments. the ability of a technology solution to add or update risk methodologies to improve accuracy has never been more important – particularly with the recent focus on VaR and its failure to signal outcomes during the financial crisis. depending on the characteristics of the instruments traded. as these best capture ‘non-normal’ events faced by institutions today. The technology must also allow extensions to market risk VaR models to incorporate credit defaults. Emerging from the financial crisis: A new era for CCP risk management 7 . the risk management technology solution must also have the capability to provide ad-hoc and immediate risk analysis should an unexpected event occur in the market. such as assessing the exposure to House and non-House positions. this relevant time is typically real-time. In the case of VaR. cashflows being reinvested or options being exercised. in order to reduce exposure to potentially defaulting members. High performance real-time monitoring provides the CCP with the opportunity to call margins when required. rather than having to wait until the end of day or longer. The system must also be able to drill down to identify and understand the drivers of underlying variations in the risk calculations. such as 4. For a CCP. An effective risk management technology solution should be able to provide CCPs with the capability to make decisions as quickly and accurately as possible. and incorporate macro cyclical macroeconomic stress-test factors. as well as low-volume complex products. risk determination is a time consuming exercise. trades maturing.

trade or position level. Clearing risk solutions to manage the default risk of members and their clients At a minimum. it is unusual for the CCP to have the same level of visibility for its members’ clients. in a system that holds all relevant trading and collateral information. The right stress-testing functionality should have the ability to apply shocks to the risk drivers across the complete data set. A CCP’s risk management technology solution must enable ‘what-if’ analysis on a market. 7. 6. Again. including non-linear OTC derivatives. Comprehensive stress-testing to assess the adequacy and liquidity of financial resources To measure and manage risk accurately in a falling market. should market events require the monitoring of specific asset classes. which can be used to understand potential exposure if a member defaults in a falling market. while actively monitoring regular member activity. However. Exercising these default procedures within the technology framework itself. This provides a vital layer of overall risk mitigation to prevent future systemic risk. The CCP should also have the flexibility to modify. the best risk management technology solutions will have the capacity to calculate risk models relevant to both the CCP’s members and its members’ clients. Where client member data is available. It should also be able to incorporate dynamic changes to portfolios over time. or apply new stress scenarios. it is equally important that the CCP can exercise these procedures to ensure their relevance in a changing market. as well as the risk drivers across all asset classes. CCPs require full transparency of exposure to their clearing members. Emerging from the financial crisis: A new era for CCP risk management 8 . the solution must be able to generate all required cash flows through time. Portfolios or trades should be able to be repriced accordingly. For liquidity risk. and coupons and swaptions being exercised. A CCP’s risk management technology solution must be able to model scenarios and the resulting risk measurements outside of the day-to-day risk monitoring activities. helps eliminate any exposure to a defaulting member. taking into account factors such as trades rolling off. meaning many CCPs lack access to important information when monitoring for the potential for default. Support risk mitigation actions with the ability to set and monitor default procedures to contain and eliminate exposures to a defaulting member Each CCP has its own set of default procedures to guide decision making should a default situation arise.5. the solution needs to have the capability to deliver this information in real time. However. to enable a rapid response. as well as alterations to market data. a CCP’s risk management technology solution must provide flexible and comprehensive scenario simulation and stress-testing across the business. to view all relevant information and be ready to take recovery action if a default event occurs.

An important first step for any CCP planning to excel in the changing regulatory and market conditions is an assessment of its current risk management architecture and technology infrastructure. In particular. CCPs are under increased scrutiny because of regulatory proposals that will see them take on an enhanced role in providing market stability and efficiencies in financial markets. This paper has illustrated the significance of effective risk management and core technology systems to the success of a CCP in this new era of risk management. This changed regulatory environment provides significant growth opportunities for CCPs.Conclusion Risk is an inherent and necessary component of global financial markets. These issues are likely to increase in complexity in an evolving global economy. Recent events have demonstrated that the way in which financial institutions measure and manage risk will differentiate them in what is an increasingly competitive landscape. It is therefore more critical than ever for CCPs to implement changes now or risk being left behind. as well as unprecedented challenges and competition. which will hopefully assist CCPs in adapting quickly to new market pressures and legislative changes as they come into play. Emerging from the financial crisis: A new era for CCP risk management 9 . This paper has outlined some key characteristics of an effective risk management technology system.

allowing clients to maximise optimal risk and reward. minimal risk implementation. Melbourne. clearing and liquidity risk within a single application. Clients use Razor’s advanced analytics and scenario calculations to achieve best practice in managing risk exposures for credit. Since Razor is a framework and not a risk measure.com +44 (0)20 7621 8520 Americas 276 5th Avenue.Clearnet in London. it’s necessary to manage the total exposure of a financial institution across all its global activities. the industry association of the world’s principal clearing organisations. The company specifically addresses the complex issues surrounding risk management – issues that were highlighted during the economic downturn with the collapse of institutions such as Lehman Brothers.razor-risk. New York and London. practitioners can easily incorporate new sources of risk and accommodate innovations in best practice risk management. Stock Exchanges.com ©2010 Razor Risk Technologies. Razor. The company operates on a global risk consultancy structure. Razor is the leading risk management framework around the CCP12 members. Banks. www. R07/10 v2. LCH.americas@razor-risk. and is used by ASX in Sydney. market. drawing upon the expertise of all employees in implementing best practices for clients’ individual needs. low cost. IDCG in New York. Hedge Funds and Brokers across the globe measure their risk and manage their capital.sydney@razor-risk. and KPEI in Indonesia. 145 Leadenhall Street London EC3V 4QT UK razor. With offices in Sydney (headquarters). All Rights Reserved. Razor Risk Technologies recognises that in order to measure and manage risk effectively.measure & control your risk About us Razor Risk Technologies is an Australian public company (ASX: RZR) focused on assisting financial services institutions worldwide to measure and control risk through professional services and its enterprise risk management product. Suite 901 New York NY 10001 USA razor. 115 Pitt Street Sydney NSW 2000 Australia razor. Razor Risk Technologies has a 100 per cent successful implementation record for its product.com +61 2 9236 9400 Europe 8th Floor.com +1 (212) 683 9445 About Razor Razor Risk Technologies’ award-winning ‘Razor’ framework provides near real-time and pre-deal calculations that enable management to view their total exposure to individual entities on one consolidated platform. ‘Razor’. This methodology supports an efficient. Razor Risk Technologies has a highly skilled team of specialists who provide risk management technology and consulting services across the financial markets and risk management sectors. . Contact us Australia Level 9. Razor has helped improve the way Central Clearing Counterparties. Razor also assists financial institutions to satisfy their requirements under the Basel Regulatory Framework and the CPSS-IOSCO Recommendations for Central Counterparties.europe@razor-risk.