Buy-Side Firms Overhaul Risk Systems and Practices
Staffers taking new approaches and enjoying management buy-in
May 4, 2009
As counterparty risk moves to the forefront and increased regulation looms, experts say the financial meltdown has transformed the notion of risk management for buy-side firms.
Automated markets "drive demand for fast solutions to manage data, analyze exposure and standardize operations," said Robert Iati, partner and head of global consulting at Tabb Group, at a roundtable in New York last month. But as losses mount and instability grows, "we need to better understand positions and counterparties," added Iati. "We need to look at more risks: operational, clearance and settlement, and counterparty. The execution chain has many types of risks that need to be managed more aggressively."
Investors are feeling the backlash from counterparty risk issues, he said, adding that the lack of standards governing valuation is a concern for two-thirds of buy-side risk managers.
The good news, said Iati, is that investment in risk technology is increasing at a healthy rate and is one of the few areas of near-term growth for both buy- and sell-side firms. More diligent risk management practices are being put into place at the urging of fund investors, he noted.
"The biggest change I have seen is that risk management has received a blessing from the top on down," said a risk manager at a large mutual fund-panelists at the gathering, which was sponsored by Boston-based risk management systems provider Sophis, asked that their names be withheld. The head of risk at a hedge fund said that his firm "went from having one to four prime brokers. Our solution was to diversify."
Participants agreed that operational risk historically has been viewed separately from other types of risk and needs to be integrated into an overall strategy. "You need to assess whether you have the right op risk programs in place," said a risk professional with a major global asset manager. "Operational risk and market risk need to work together to make sure that operational risk becomes part of standard decisionmaking."
Operational risk issues-particularly rogue trading as was seen in the Société Générale scandal last year-have not received the attention they deserve, according to Iati: "The need to play by the rules is not being stressed enough, including not watching for operational or ethical lapses, and not being prepared to react."
Failures of VAR
Methodologies will also have to change. The reliance on a normal distribution for measuring risk will likely decrease, said roundtable participants, who concurred that value at risk (VAR), a popular measurement, has limited utility. "Risk management can give you warning flags, not necessarily an exact number," said the mutual fund risk manager. "VAR is just a number, like a speedometer," added the hedge fund executive. "If it is in your car and says you are going 80 miles per hour, that is one thing. If it is in a plane, 80 miles per hour means something else entirely."
Iati called VAR "a valuable tool that doesn't measure the full spectrum of risk. The problem is that it was viewed on a holistic level as the only tool, instead of part of the toolbox. They were looking for a tool to measure risk completely. It was in fact an operational issue. It is the fault of us as an industry for not having sufficiently broad measures to use."
