Given the current market conditions and events of the last nine months, managing counterparty risk is of increasing importance for fund management companies. But how can fund managers ramp up their risk management resources to implement the controls they need to manage counterparty risk in these tumultuous times? Michael Bryant of InteDelta, explains the basics and how any firm can effective make changes now.
If there is one thing the events of the last year have shown us, it is even the biggest and most established banks are vulnerable in the wake of the subprime crisis and near systemic failure of the financial markets. Some investment banks have gone under and others were rescued by either the government or quick acquisitions. The swiftness of the downfall of these institutions and domino effect on other financial players revealed the importance of managing counterparty risk effectively to many worried buy-side institutions.
Historically, hedge funds were viewed by banks as high risk counterparties, but now the shoe is on the other foot; fund managers of all shapes and sizes have to ramp up the previously neglected counterparty risk management procedures and controls.
Buy-side firms, especially the smaller firms, cannot compete with the resources and budgets of a bank, but no matter what the size and shape of a firm the same four components apply when implementing a solution for managing counterparty risk.
The four main principles are: establishing a risk appetite, measurement of exposures, use of risk management systems and documentation and collateral.
First off, a fund manager must establish their risk appetite so the portfolio managers know exactly the amount of exposure they can take on when trading with counterparties. Firms relying on a single broker have higher concentration risk than those who rely on multiple brokerage firms. Of course, relying upon multiple prime brokers does incur additional operating inefficiencies and cost and this needs to be balanced against the advantages of diversifying counterparty exposure.
Once the risk appetite is established, a fund manager must establish the method used for measuring exposures. Potential future exposures (PFE) is a commonly used methodology for quantifying counterparty risk and fund managers can calculate PFE range differently by using notional values, add-ons, and Monte Carlo simulation, (the most sophisticated method which models the progression of the mark to market value of each transaction). Many of these PFE methodologies may include risk mitigation and portfolio effects (e.g. portfolio diversification and collateralisation). Sophisticated methodologies such as Monte Carlo may not be appropriate for smaller fund managers, but all managers should establish a mechanism for the measurement of counterparty risk.
In addition to PFE, settlement risk (the exposure on trade settlements outstanding if a counterparty defaults) should be quantified and subject to limit.
To manage counterparty risk, a systems solution is essential. For a smaller institution, reliance on spreadsheet monitoring may be enough but the larger firms will required a full equipped counterparty risk management system such as the systems used by the major banks. A counterparty risk management system executes two major functions: exposure and limits management and the calculation the counterparty exposure, which is executed by a risk engine. The former maintains credit limits and monitors exposures again those limits. For a larger fund manager, and one with multiple dealing locations, additional functionality such as pre-deal checking and workflow functionality for monitoring exceptions, may be needed.
The complexity and size of the risk engine is dependent upon the method used to measure the exposures. So a larger fund manager who uses Monte Carlo simulation approach to measuring risk exposures, implementing an exposure monitoring system and risk engine will be a much bigger project.
Use of Excel or Access might be doable for a smaller fund manager, but for the larger firms and those needing a more complex and robust risk management solution, there are systems available and provided by software vendors or hosted service solutions firms can subscribe to.
A number of the major trading and portfolio management system vendors offer a counterparty risk module as part of their application which may be a good option for a fund manager that uses a single system for trading functions. There are also other stand-alone risk management solutions which often offer integrated market and counterparty risk functionality.
And finally, it’s all fine and well to have the risk appetite established, exposures efficiently monitored and calculated regularly via an established risk engine, but documentation and collateral are the final and equally important pieces of an effective risk management strategy.
The collateral terms of a transaction are defined in either the prime broker agreement (bespoke agreement between fund manager and its broker) or documented under ISDA documentation format, which relies on the Credit Support Annex (CSA) for the specification of collateral terms. In the agreement, a fund manager can assert if the collateral requirements are bilateral or unilateral. Bilateral terms means both parties will have to deposit collateral of the market to market value of the portfolio moves in its favor and unilateral means only the fund manager needs to do so. Obviously bilateral terms provide a manager more protection against credit risk and counterparty exposure. The prime broker agreements must also be reviewed to ensure the exposures they face and agree to if the broker were to default – a more realistic event in current times.
In summary, the market as a whole does not know what is around the corner in these turbulent market conditions. Any fund manager should, at the absolute minimum, implement a counterparty risk management solution which incorporates all these four main components. A solution which caters to the size of a firm, resources and budget available can be created and provide a fund manager the risk controls required to survive in these tumultuous time. There is not time to wait.
*Michael Bryant is the managing director of risk management consultancy, InteDelta.