Sophisticated Risk Management Tools Critical for Exchanges and Clearing Houses

By Malcolm Warne Vice President, Product Manager, Risk Management NASDAQ OMX Market Technology
Traditionally, sophisticated enterprise risk management has been the domain of large broker dealers, driven by regulatory capital requirements and optimising return on risk capital. However, the increased systemic importance of exchanges and central counterparties since the 2008 financial crisis has raised the bar on risk management requirements for these institutions.
Clearing houses will have exposure to the same customers across multiple asset classes. OTC-traded financial instruments will have to be cleared through CCPs. While these factors increase the need for sophisticated post-trade risk management, they also provide strategic opportunities to lower costs, reduce potential losses and increase profits. Clearing houses that can provide the best-in-class services enabled by sophisticated risk management will be well positioned to attract and retain business in a centrally cleared environment.
Hallmarks of best-in-class risk management systems include support for the following:
• Cross margining to reduce margin requirements.
The global introduction of OTC Clearing plus the proposed Basel III requirements will increase the overall collateral obligations for clearing members and increase the imperative for them to use scarce available collateral as efficiently as possible. These changes also generate the opportunity to significantly lower margin requirements through cross margining. A sophisticated risk management solution will enable marketplaces to determine margin offsets within and across asset classes by calculating risk offsets across the entire portfolio. The benefits of this can be significant especially across listed and OTC portfolios of the same underlying asset class. According to TABB Group estimates, when all clearable interest rate swaps are eligible for portfolio margining, the additional margin requirements could be lowered by at least 32%, and the industry will see margin savings of at least US$618 billion.
• Real-time risk data.
Access to high quality, real-time risk information is critical for decision-making and is especially important in a stressed volatile market where risk exposure is constantly changing. With up-to-date information, clearing houses can use strategies such as intraday margin calls, member suspensions and hedging defaulting member positions to minimise losses by managing risks as they occur.
• Automated risk policy to reduce costs.
Automating risk policy enables clearing houses to set limits and continually monitor activity to detect and curb breaches. Sophisticated alarm handling ensures enforcement of risk policies by escalating any limit breaches for appropriate action. Clearing houses can lower fixed costs and free risk managers from tedious monitoring and report checking so they can focus on strategic risk management.
• Clearing certainty to maximise potential business and stay within credit limits.
In centrally cleared environments, clearing members generally need to extend credit to create a level of certainty that their trades will clear. To ensure that new deals are within acceptable credit limits and reduce the risk of trade fails, clearing houses will need to establish automated pre-trade credit checking routines. A sophisticated risk management system will offer both Push and Ping methods to support these credit checks. While the Push approach “pushes” credit availability to trading systems, the Ping method performs pre-deal checks in the risk management system prior to accepting deals for clearing. The Ping method is more appropriate for OTC Clearing and should be both fast and also take into account risk offsetting across the entire portfolio to maximise available credit without exceeding limits.
• Calibration of guarantee fund and margin to achieve optimal balance.
It is essential for clearing houses to maintain the proper balance between protecting the clearing house and its members in a default situation without placing too onerous a demand on limiting acceptable collateral. A sophisticated risk management system will provide the stress testing and back testing capability necessary to calibrate both the guarantee fund and initial margin calculations. This ensures the adequacy of these resources in all market conditions and also provides much needed transparency to clearing members.
• Nimble risk technology to quickly take advantage of new opportunities.
An agile, modern risk management solution is the engine that can power new revenue streams. These opportunities can include the clearing of new OTC asset classes brought on by regulatory changes and improved margin calculation. Having an agile risk platform enables exchanges and clearing houses to respond quickly and cost effectively to opportunities when time-to-market is critical.
• Value added SaaS Risk software can generate additional revenue and increase customer stickiness.
The increased market acceptance of hosted software services provides an opportunity for exchanges and clearing houses to offer their risk management functionality as a hosted service to clearing members and clients of clearing members. One potential service is margin optimisation, where clients can analyse their portfolios and perform what-if analysis to determine the most capital efficient way to amend their portfolio. These value added services can help marketplaces differentiate themselves and generate additional revenue via subscription fees.
Investing in a sophisticated risk management solution provides clearing houses with the flexibility to quickly adapt and to provide the necessary tools and transparency to their members. At the same time, this investment can generate additional returns by creating new opportunities to lower costs, reduce potential losses and increase profit while protecting the integrity of the clearing house and its members.