Blog Ideas, Thoughts, and Industry Shifts
Credit, Market and Trading Pricing Accuracy: the Convergence
PPG approaches risk component integration with solutions centered on the recent and growing credit integration of traditional credit monitoring with regulatory drivers in capital management, credit charging and alignment of front-office trading prices.
The process of managing credit reserve, and in fact the sophistication of the associated calculations, differ across the institutional banking tiers and range of buy-side institutions. The common element across each of these institutions is the need to manage available capital.
Differences in approach include:
- The level at which the bank actively manages or warehouses assessed risk: the extent of how functions are centralised or aligned with the trading desks (ie: a centralised group function, or managed at a desk/group level charge from Finance)
- Scope of what risk is assessed for externalised risk and hedging purposes, based on the appetite of warehousing, and what levels of risk are to be externalised (ie: above the credit-limit utilisation capital relief for counterparties vs. the managing the whole counterparty exposure)
- The extent of how credit charging is managed: it can be first an assessment calculation, then a hedging strategy and then separately a risk-externalisation strategy involving contingent-credit derivatives
- The extent of hedging of sensitivities (either market or credit) and how they are reconciled back to the front-office trading systems
- Model choice (partial estimations or simulated; market-implied, or risk-neutral, historic) dependent on the level/strategy of externalisation and the extent that externalised risk vehicles are marked to market
- Scope of product/trading book coverage, range & strategies for liquid and illiquid names, and the types of exposures covered
The focus in recent markets on capital, and portfolio exposure restructuring, is only one example of a broader pattern of convergence of trading practices with credit and market risk assessment solutions, that includes E/C and RegCap.
- The recent market demand shows that there is a continued convergence of trading practices with credit and market risk assessment with trading practices.
- This convergence is primarily driven by capital relief in the current credit-constrained markets and the need for assessment and externalisation strategies involving an increased use of securitization & contingent-credit vehicles (with CCDS, CDOs, CLO, etc..)
- This convergence is further driven by the need for further transparency in managing the cost of capital, internal re-insurance, and enhanced hedging requirements in the credit markets (with CDS, CDX, CLN, etc..)
- A broader capital/balance sheet management process, especially important in today’s credit constrained market, is driving the need for a more extensive and accurate set of instrument, simulation, and attribution analytics; enabling trading teams to ultimately externalise risk at market value, rather than typical risk assessment tolerances.
The goal in addressing the market as a whole, and capitalising on the convergence trend, is to ensure that any risk offering can meet the stringent front-office pricing requirements for risk assessment, and is flexible enough to deal with the workflow required between a centralised risk function and reporting for RegCap, E/C, and CVA.
The ability to achieve cross counterparty accuracy required for trading and capital relief management purposes, requires a broader set of portfolio, market/pricing, attribution, and trader workflow frameworks that typically fall between most enterprise risk management and/or trading/limit mgmt solutions.
While accuracy reconciliation is key, reusable calculation frameworks for simulation-based risk must supply PFEs, EPEs, and MTM profiles, all of which can in turn be used for RegCap, E/C, CVA, and hedging purposes. Necessary features that are explored lie in model accuracy, instrument reconciliation, portfolio management and attribution, and trader workflow modules necessary for managing and performing portfolio reviews.