David Rowe’s Risk Management Blog

The publication of the third Counterparty Risk Management Policy Group position paper on August 6, 2008 represented a stark challenge to the OTC derivatives business. Co-chaired by Gerald Corrigan of Goldman Sachs and Douglas Flint of HSBC, the Policy Group includes four major investment banks, five global commercial banks, two major buy-side firms and one prominent law firm. Two other commercial banks plus the DTCC and ISDA were represented on one or more working groups. (See http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/Towards%20T+0%20Reconciliation.pdf for a comment and
http://www.crmpolicygroup.org/docs/CRMPG-III.pdf  for the full report.)

The most daunting recommendation is to challenge the industry to undertake a crash program to achieve full T+0 confirmation and reconciliation on a fully electronic basis by the end of 2009. The internal risk management benefits of such a system are indisputable. It would:

make rogue trading harder to conceal

reduce the cost of manual investigation and deal mismatches and

facilitate back-office consolidation across products among other benefits.

Perhaps most importantly, by forcing daily full book reconciliation it would provide a solid foundation for up-to-date counterparty exposure tracking.

Such a system would have one other feature, however, that needs to be considered. It would slow the rapid pace of innovation characterized by willy nilly development and execution of ever more complex transactions. Often such trades exist only on spreadsheets developed by quants on the desk and require ad hoc workarounds to support life-cycle processing (daily mark-to-market, payment processing, etc.) From a risk standpoint, replacing such unsatisfactory arrangements is yet another positive contribution but it strikes at the heart of the central competitive strategy of players in these markets.

Ten years ago, demanding electronic production system processing of every trade would have represented a major obstacle to the development of new structures. Front and back office systems tended to be closed and difficult to enhance. Today tools exist that would allow significant innovation to continue despite T+0 reconciliation. These include XML-based transaction description protocols and general purpose solution tools that can handle most complex structures. While these tend to be fairly inefficient computationally, they provide a significantly more robust alternative to spreadsheets where quality control is notoriously difficult to maintain.

A consortium of major dealers is reportedly targeting October 31 as the deadline for agreeing on a strategic roadmap for T+0 confirmation of credit default swaps. Meeting this self-imposed deadline is the first test of how serious this effort really is. The bigger question, however, is how aggressively the industry will pursue the internal developments required to bring such a system into production. Is the will there to do the right thing? Based on past history my cynical nature harbors serious doubts. If progress is slow to materialize, however, the industry may be missing its last chance to avoid a regulatory crackdown. The demise of Bear Sterns demonstrated the potential systemic risk posed by shoddy settlement practices. I am inclined to think this systemic risk can be overplayed. (See http://www3.sungard.com/SunGardFinancial/menus/documents/5Really%20too%20big%20to%20fail.pdf). Nevertheless, uncertainty about the amount of exposure to a failed counterparty, and about the transactions required to rebalance the books of surviving firms, can have systemic implications. It is unlikely that regulators will refrain much longer from imposing specific operational requirements if the industry drags it feet much longer.

Comments please…