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…

One argument supporting the alternative beta view is the comparative success in efforts to replicate the returns of specific hedge fund strategies using fixed or mechanically rebalanced portfolios of tradable instruments.  See http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/200708%20is%20it%20really%20alpha.pdf for my August Risk magazine column discussing this issue in more detail.

I am curious how readers view this issue.  If hedge funds really are producing “pure alpha” returns, how does one explain the rash of synchronized losses we are seeing currently?

The market standard Gaussian copula model for pricing CDOs is notoriously simplistic, requiring inconsistent correlation assumptions to match the prices of different tranches in a single CDO pool.  For actively traded structures this does not raise serious doubt about fair value estimates since there are observed prices at which significant numbers of trades actually occur.  But what about less liquid structures that do not have a regular two-way deal flow?  This is certainly not a new problem.  It has long plagued the municipal bond market in the US where many local issues only trade infrequently.  In that market the usual strategy for valuation is to apply a matrix technique where observed trades for similarly rated bonds are used to estimate the fair value of ones that have not traded. 

Municipal securities are relatively simple, however, compared to sub-prime mortgage pools where thin trading is also a problem.  In such a space, mark-to-market versus mark-to-model becomes an important distinction.  Significant volumes of highly complex illiquid securities can end up being valued based on very limited trading volume of similar issues.  Modest demand shifts can have a significant impact on prices for the daily trade flows.  The effect can then be magnified as these observed prices are used to value the much larger volume of outstanding issues. 

One theory is that the recent troubles at two hedge funds run by Bear Sterns have been driven by this type of effect. (See CDOs: “A Triumph of Greed Over Fear” at http://www.riskcenter.com/story.php?id=14943.)  A significant source of concern is the extent to which other hedge funds have similar problems in their sub-prime mortgage portfolios that have not yet emerged.  It also raises doubts as to whether most hedge fund returns are genuinely based on alpha or are a sophisticated form of alternative beta driven by esoteric but identifiable market factors whose behavior has been relatively benign in recent years.

Certainly many readers out there are much closer to this unfolding issue than I am.  How do you think this story will unfold in the coming days and weeks?

Some banks learned very early that they reap a huge benefit when customers shift to on-line bill payment, since customers themselves enter the electronic information that becomes the basis for the ensuing transaction.  This eliminates a great deal of internal manual entry that is both costly and error prone.  For this reason, most banks quickly eliminated extra fees for on-line banking privileges, since maximizing the number of customers using this service is highly advantageous.  This point needs to be remembered when it comes to weighing the cost of improved on-line security measures.  Even if long-standing customers don’t switch to another bank when they are nervous about security, they still may revert to using old fashioned checks rather than banking on-line.  It seems to me that progress in this area has been surprisingly slow given that there are both competitive advantages and risk control benefits from more advanced security measures.

For those interested in the specific area of identity theft and examples of both good and bad practice, an interesting website is http://www.meandmeblog.com/.  Two recently featured stories concern:

- A man who was arrested for a crime committed by someone else who had stolen his identity.
- A charitable organization (which I will not name but you can find its identity at http://www.meandmeblog.com/ in the Latest Comments section) that sent out a solicitation letter to supporters with their social security numbers on the OUTSIDE of the envelopes!

Surely the second of these indicates that some “awareness enhancement” is required around the issue of securing personal information in our brave new world of electronic commerce.

(I am reminded of a cartoon I saw about ten years ago, when the web was in its infancy.  It showed a Dalmatian sitting in a desk chair in front of a computer and saying to his companion standing on the floor, “The best thing is that on the internet no one knows you’re a dog.”)

In brief, Geithner’s points are as follows:

HISTORICAL CONSIDERATIONS: Financial innovation is not new. Growth in loan syndication, increasing provision of credit directly through the capital markets, development of various asset-backed securities and segmentation of different aspects of credit risk have been occurring for over two decades. The performance of the economy and financial markets during this period is broadly encouraging. The US financial system absorbed the surge in corporate defaults in 2001 and 2002 remarkably well, with no near-default of a major bank.

Credit market innovation has not resulted in a significant increase in corporate leverage as some predicted. Non-financial corporate leverage in the US is relatively low by recent historical standards. Default rates have not risen and recovery rates have not fallen as these historical innovations unfolded.

Finally, while many factors have been in play, GDP volatility has actually moderated at the same time as these credit market innovations occurred. While this greater economic stability cannot be attributed to such innovations, experience offers some reassurance that these innovations have not caused the opposite to occur.

INCREASED ROLE OF UNREGULATED ACTORS: Recent innovations have reduced the share of non-farm non-financial sector credit held by banks from over 30% twenty years ago to around 15% today. A much larger share of credit exposure is held by non-bank financial institutions that mark to market and often assume considerable leverage. In a period of stress, the process of meeting margin calls and hedging against further losses can lead to a positive feedback loop that deepens the impact on credit markets. This effect may be mitigated by the greater spread of the risk among diverse institutions and the reduced moral hazard associated with banks’ access to the public safety net.

INCREASED COMPLEXITY OF NEW INSTRUMENTS: Managing the new array of credit risky assets is complicated by their very complexity. Appropriate hedge ratios among tranches of CDOs, for example, are notoriously uncertain. Recent innovations also have increased the distance between originators of credit and those who ultimately hold the exposure. This gives rise to a classic principal-agent problem. The usual checks and balances designed to control such problems rely fundamentally on the ability to understand the nature of the underlying risks involved. To the extent that the risks are more opaque because of complexity, imbedded leverage and short loss histories, these checks and balances may be less effective.

THE MECHANICS OF DEALING WITH A FAILURE: The very complexity and shear volume of transactions and counterparties could prolong the uncertainty created by the default of a large institution. This could well be exacerbated by the failure of infrastructure to keep pace with the growth of the underlying volume and complexity of transactions. 

A lingering concern is whether the credit trading/credit derivative market itself is robust enough to function smoothly in a severe downturn.  Will the apparently greater diversification of credit risk created by an originate-and-distribute approach to the banking business continue to function smoothly under stress?  Regulatory concern about sloppy operational processes in the credit derivative market is largely motivated by its importance for stability of the banking system as a whole.

Clearly there is no definitive answer as to how serious a risk is implicit in the operational fabric of the credit derivatives market.  Nevertheless, I am interested in your views on how much progress has been made since regulators began emphasizing the issue.  If you know of formal studies that have attempted to assess the impact of credit trading on systemic risk of the banking system, these also would be interesting.

Americans of a certain age will remember comedian Pat Paulsen’s mock campaign for the presidency.  One of his skits involved a reporter asking, “Mr. Paulsen, what is your position on the population explosion?” 

“Well,” he responded, “I’m glad you ask because I’m something an expert on the population explosion.  You see, I was in India the day it happened!”

At a recent PRMIA seminar in London, an actuarial consultant stated that the advances in life expectancy in Britain in the past 15 years have been equal to those of the prior 150 years!  This is not a pace of change likely to set a hardened trader’s nerves on edge (or to rob the humor from Paulsen’s quip) but it certainly is enough to get the attention of insurance companies that underwrite life annuities.

The real question is whether an index such as LifeMetrics has produced will generate enough two-sided interest to produce reasonable liquidity.  I am interested in your reaction on whether this is the start of a major incursion of capital markets into this arcane form of risk or is it another false dawn?

1. Praise the new technology, but insist that it is of no broad, practical use.
2. Ridicule it.
3. Pedantically argue about meaningless, minor aspects of the technology.
4. Decide that the technology has a future and argue violently for the dominance of their own version.
5. Adopt the standard set by whomever won the battle in step 4.
6. Take the whole thing for granted and completely forget that any of steps 1-5 ever happened.

Vance argues that risk management, the origin of which he dates from the mid-20^th century, is firmly in stage four.  He says: “The trend is clear. Using the internet as an analogy, I think we are about 1992 in the world of risk management. I can’t think of any better news for those of us in the profession. We are riding an incredible, global wave.”

So what do you think?  Are we on the verge of a virtual explosion in the impact of risk management?  Is it reasonable to compare the potential impact of risk management to that of the internet?