INsight - Quantifi Newsletter issue 03


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The Evolution of Counterparty Credit Risk: An Insider's View
Quantifi CEO, Rohan Douglas, talks about the latest release
Q&A with Olivier Renault of Stormharbor

Published in: Economy & Finance, Business
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INsight - Quantifi Newsletter issue 03

  1. 1. INNEWSLETTER ISSUE 03 SIGHT 2011THE EVOLUTIONOF COUNTERPARTYCREDIT 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. 2. MESSAGE NEWSFROM Client News:THE CEO Varden Pacific Selects Quantifi to Power OTC Trading and Regulatory Compliance “The unique combination of intuitive data management, fast and accurateEven though regulatory uncertainty and market volatility risk analysis, and flexible, detailedcontinue to dominate the OTC markets, we are seeing reporting gives us the confidence toinstitutions that are profiting from being able to capture make informed investment decisionsopportunities as they arise. This is an environment where an whilst providing the transparency andinvestment in better analytics and risk management can make a robust infrastructure our investorsdifference to profitability. In a similar way, we believe a proactive require. Quantifi Risk was deployed ininvestment in infrastructure to support central clearing and new a matter of days. As it required minimalregulations will make a difference to future profitability. internal infrastructure and resources, we were able to enter the market quicklyOn the subject of investing in infrastructure - technology is and achieve an immediate return on ourplaying an increasingly important role for the OTC markets and investment.” - Shawn Stoval, Managingthis trend is likely to accelerate with the introduction of central Partner, Varden Pacificclearing. The complexity of the trading, operational, and riskmanagement systems required to support OTC businesses Prosiris Selects Quantifi for Riskhave dramatically increased. Comparing state of the art from Management and Reportingten years ago to state of the art today highlights the challenges “Given the sophistication of our tradingof developing systems that not only meet current needs, but strategy, the key factors in selectingalso are flexible enough to keep up with future demands. Quantifi Risk are industry leading analytics combined with flexibility and usability. AsAt a time when the cost of capital is increasing and profitability a recognised leader, Quantifi provides theis uncertain, the accurate and careful management of capital level of accuracy and sophistication weand return on capital becomes essential to a firms survival. As need to trade and effectively manage ourthe complexity of technology infrastructure increases, cost and risks. By partnering with Quantifi we nowproject risk dramatically increase. An estimated 50% of large have the opportunity to focus our capitalIT projects fail (Harvard Business Review Sep’03). This failure and time on our core business rather thancarries both a huge cost risk as well as opportunity risk to spend time and resources developing anbusinesses that depend on timely delivery of this infrastructure. internal solution.” - Jerry Chang, ChiefThis shifting dynamic is re-defining the efficient boundary of Financial Officer, Prosiristhe buy versus build decision. As IT becomes more strategic,institutions need to carefully evaluate and manage their IT spendand 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 15This month we have some exciting corporate news. I amdelighted to welcome Dmitry Pugachevsky, former head of Dmitry Pugachevsky, Director, Research atcounterparty credit modelling at JP Morgan, as Research Quantifi, leads post-conference seminarDirector. Dmitry is a well-known figure in the industry and his on counterparty credit risk and CVAextensive counterparty credit and broad cross-asset modelling Quantifi Seminar: Counterparty Riskexperience 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 18development and our commitment to ensuring our clients Join Quantifi & PRMIA for an interactiveremain competitive by being well-prepared and strategically seminar on counterparty risk and CVA andpositioned 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 402 |
  3. 3. Rohan Douglas, CEO of Quantifi, talks aboutthe latest version release of its pricing and riskanalytics software, Quantifi QX.1Driven by client needs and transformations in the OTC markets, QX.1 (V10.1) includesa broad range of enhancements across Quantifi’s entire product range includingenhanced 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 interfacesregulatory and market environment. Our goal is to Leverage Quantifi to support a broader range ofprovide clients with a smooth transition to central traded asset classesclearing, valuation model changes and future regulatory More easily interface with additional datademands including Basel III. Helping our clients focus vendors with expanded out of the box supporton their core business by providing them with tools that Provide on-desk CVA pricing integrated withthey can depend on has always been a priority. Another Quantifi’s pricing and structuring solutionskey goal for QX.1 has been responding to client demand Implement Basel III compliance with enterprisefor broader asset coverage. counterparty risk solutionsHow does QX.1 support the ongoing OTCmarket changes?Regulatory and structural changes in the OTC WHATS NEW IN QX.1?markets are having a profound impact on all aspectsof technology, research, and operations. QX.1demonstrates our long history of being able torapidly evolve ahead of the market and introduces enhancements for FX, FX Forwards, FXinnovative new functionality as well as broader asset Options, basis swaps, callable bonds, convertible bonds, FRAs, Swaptions andcoverage 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 managementHow will your clients benefit from QX.1?We work hard to make sure our migration process is play client model integration, productsmooth and simple. Clients will be able to leverage extendibility, and data integrationnew features immediately. I would expect keybenefits 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 | 03
  4. 4. COVER STORYTHE EVOLUTIONOF COUNTERPARTYCREDIT RISK: An Insider’s ViewBY DAVID KELLY, Director of Credit, Quantifi a single number that could be used for rudimentaryand JON GREGORY, Consultant calculations. In contrast, the more derivatives oriented investment banks calculated reserves by simulatingCounterparty credit risk management has been evolving potential future positive exposures of the actualfor over a decade from passive risk quantification and positions. The simulation models persevered becausereserves to active management and hedging. The term they more precisely valued each unique position andCVA (credit value adjustment) has become well-known directly incorporated credit risk mitigants.and represents a price for counterparty risk. Substantialresponsibility is being transferred from credit officers to By 2000, the simulation based CVA and economicCVA traders, groups with the responsibility of pricing capital reserve model was state of the art althoughand managing all the counterparty risk within an only a few institutions were able to perform exposureorganisation. Banks today tend to be distributed along limit checks and calculate pre-deal CVA on a real-timethe evolutionary timeline by size and sophistication. basis for new transactions. Institutions had expandedWhilst global banks are focusing more on hedging CVA, portfolio coverage in order to maximise netting anddriven by dramatically increased capital requirements diversification benefits. However, the down credit cycleunder Basel III, smaller and more regional banks, initiated by the Enron and WorldCom failures, followingtogether with other financial institutions such as asset the wave of consolidation and increased concentrationmanagers 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 toReserve models are essentially insurance policies reduce large exposures, there had been limited effort inagainst losses due to counterparty defaults. For each actively hedging counterparty credit risk. The need totransaction, the trading desk pays a premium into a increase capacity, as well as changing standards for fairpool from which credit losses are reimbursed. The value accounting (IAS 39 and FAS 157), spawned twopremium amount is based on the creditworthiness of significant and mostly independent solutions. The firstthe counterparty and the future exposure, accounting solution, driven by the front office, involved pricing andfor 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 usedreserve models and exposure limits, but the underlyingmethodologies were very different. Front-office market model An innovation that emerged in the mid to late 90’s wasBanks 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 theterms. In the early days, loan equivalents were critical to position level like other market risks. There weresimplify a potentially quite complex future exposure into two ways to implement this ‘market model’. The first04 |
  5. 5. involved valuing the counterparty’s unilateral option to frequency, although ongoing numerical anddefault. The second used the bilateral right of setoff, technological innovations are collapsing these times. Inwhich simplified the model to risky discounting due to addition, residual correlation risks, including wrong-waythe offsetting option to ‘put’ the counterparty’s debt risks, continue to pose a significant challenge.struck at face value against an exposure. Current prioritiesA few institutions considered transitioning as much Since the onset of the crisis, firms that had aof their credit portfolio as possible into the market comprehensive, integrated approach to credit riskmodel, using bilateral setoff wherever possible and the management survived and emerged while those that hadunilateral option model for the rest. The idea seemed a fragmented approach struggled and failed. This punchreasonable since over 90% of corporate derivatives line and the evolutionary process that helped deliverwere vanilla interest rate and cross-currency swaps. it have resulted in a general convergence toward theAside from the obvious issues, e.g., credit hedge portfolio simulation model with an active managementliquidity, the central argument against this methodology component. Several global banks are setting the standardwas that it either neglected collateral and netting or for best practice whereas most mid-tier and regionalimproperly aggregated net exposures. The ultimate banks are still balancing the need to comply with CVAdemise of the market model as a scalable solution was accounting requirements with more ambitious plans.that the marginal price under the unilateral model wasconsistently higher than under the simulation model. Global banks are pushing the evolution in three main areas. First, there is a recognised need to incorporateAnother detriment was the viability of having each wrong-way risk. Basically, wrong-way risk is the case wheretrading desk manage credit risk or be willing to transfer the counterparty’s probability of default increases with itsit to a central CVA desk. In addition, systems had to be exposure. Second, recognising collateral risks in terms ofsubstantially 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, includingover pricing and P&L. In short, the substantial set of exotics, increases the effectiveness of centralised creditissues with the market model caused firms to revisit pricing and risk management. Since a disproportionatethe 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 reservemodel and into a market model inspired important Basel III provides more incentive for centralinnovations in the simulation framework related to active counterparties due to the near zero risk weightingmanagement. Banks had been executing macro or of cleared positions. In addition, the Dodd-Frankoverlay CDS hedges, which were effective in reducing legislation in the US and EMIR in the EU mandatescapital requirements but ineffective in that the notional clearing as broadly as possible. Other influentialamount was based on a statistical estimate of the provisions in Basel III are the additional charges for CVAexposure, not a risk-neutral replication. In addition, that VaR. With the volatility of credit spreads and potentialexposure (notional) varied over time. magnitude of CVA VaR, which may double or even triple regulatory capital requirements for counterpartyThe introduction of contingent credit default swaps risk, banks are incentivised to actively hedge CVA.(CCDS) addressed the varying notional by setting itto the fluctuating value of an underlying derivative Another key recent priority has been the use of bilateralcontract. Whilst CCDS are tailor-made to transfer over unilateral CVA. Bilateral counterparty risk is oftencounterparty risk within a given contract, extending expressed as DVA (debt value adjustment), whichthem to cover many netted contracts with collateral mirrors CVA. Prior to 2007, financial credit spreads wereagreements would be extremely complex, not least extremely low and there was little interest in accountingin terms of the required documentation. For these for DVA. However, the recent severe deterioration ofreasons, the CCDS product has not developed strongly all credit spreads, including financials, has incentiviseddespite the increasing focus on counterparty risk. banks to price DVA in order to offset CVA losses. Although counter-intuitive, since the bank makes moneyHedging also involved perturbing the market rates when their own credit spread widens, the use of DVA hasused in the simulation and then calculating the become common and generally accepted.portfolio’s CVA sensitivities, which could then beconverted to hedge notionals. This helped stabilise These priorities were a direct result of recent events butthe CVA charge and reduce economic capital reserves most are not new. Counterparty credit risk remains a verythereby improving incremental pricing. There were complex problem and institutions have had to approachseveral issues with this approach. Simulation of the it in stages. Current best practice is the result of a longentire portfolio could take hours and re-running it and iterative evolutionary process from which we canfor each perturbed input has restricted rebalancing expect another round of innovation. | 05
  6. 6. Q&AFEATURE 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 whatStormHarbour is an investment banking partnership do you consider to be the most significantfocused 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 insecuritised 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 thatactive in secondary sales and trading, as well as 2011 would be the year of the re-opening of primaryprimary markets (raising capital for corporates, banks markets. In fact we saw very little action in public marketsor specific infrastructure projects) and advisory. but primary issuance was still dominated by retainedThe 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 volatilityWhat is your role within the company? in secondary markets with the end of the big rally whichI’m responsible for the Structuring & Advisory team in started in 2009 followed by a spectacular sell-off.London. We focus primarily on financial institutions andprovide advisory services as well as assistance in the What key challenges and/or opportunities doesstructuring and placement of new transactions. To give the current environment bring to your businessyou 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 Europeanrevolving around its bid to take over a European bank. We sovereign risk and its impact on credit and otherhave also been mandated to provide advisory (valuations, markets. While a bit of volatility is good to spur anstress testing, restructuring proposals) on about $20bn active trading market, too much uncertainty leadsof assets for half a dozen institutions over the past year. to low volumes of flow trades and a moribundFurthermore, 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 a06 |
  7. 7. A Quantifi Clientsignificant pickup in M&A transactions in the financial Sometimes flow trading is the main revenue generatorsector. StormHarbour is very well positioned to for the firm because clients are particularly active andassist governments, public sector entities and banks want to either liquidate positions or acquire risk. Morebecause we have a combination of skills in financial recently the volatility has frozen a lot of the flow activityassets, real estate as well as infrastructure finance, and it was nice to see other areas of the firm, primarilywhich 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 usLooking ahead, what market developments significantly from small advisory shops or pure brokersdo you anticipate? who are relying only on one business line. That is alsoRegulatory pressures are going to penalise banks reflected in our advice: because we have both advisorysignificantly in particular for structured credit. and execution capabilities, we can recommend solutionsFurthermore their difficulties in securing cheap long that are really actionable, not purely theoretical.term funding will lead banks to retreat again fromcommercial real estate, long term corporate lending “ While a bit of volatility is goodand infrastructure financing. This is a great opportunity to spur an active trading market,for us to get real money clients involved in these marketsand arrange transactions that bring alternative funding too much uncertainty leads toproviders to banks. We also expect to increase our low volumes of flow trades and amarket share in secondary structured credit trading moribund primary market.”as banks progressively step back due to increasedcapital requirements. What differentiates us from banks is mostly the fact that we work for clients and not for our own book. SoHow does StormHarbour differentiate itself our advice is not tainted by whatever legacy positionfrom its competitors? we may have, and because we act as arranger andDiversification is key. StormHarbour has geographical placement agent on structured trades, rather than asdiversification – we are active in the US, Europe and counterparty, the real economics of the deals are muchAsia – and also product and services diversification. more transparent to our clients. | 07
  8. 8. Whitepapers VideosOIS 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 inA COUNTERPARTY RISK counterparty risk management by tracingMANAGEMENT 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 HireDMITRY PUGACHEVSKY, DIRECTOR, RESEARCHDmitry joined Quantifi in September 2011 and is responsible for managing Quantifi’sglobal research efforts. Before joining Quantifi, Dmitry was Head of Counterparty CreditModelling at JP Morgan. Before starting at JP Morgan in 2008 Dmitry was Global Headof Credit Analytics at Bear Stearns for seven years. Prior to that, he worked for eight yearswithin the analytics groups of Bankers Trust and Deutsche Bank.ABOUT QUANTIFIQuantifi is a leading provider of analytics, trading and risk management software for the Global Capital Markets. Our suiteof integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposuresand 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 largestglobal banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and otherfinancial institutions across 15 countries.Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-marketwith intuitive, award-winning | www.quantifisolutions.comEurope: +44 (0) 20 7397 8788 North America: +1 (212) 784 6815 Asia Pacific: +61 (02) 9221 0133Follow us on:© Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Toolkit, Quantifi Counterparty Risk, Quantifi CVA are trademarks of Quantifi Inc.