Having spent 2009 coming to terms with the business and risk implications of the global financial crisis, brokers are implementing systems that will at last give them a comprehensive view of counterparty risk, claims Frederic Ponzo, managing director of Grey Spark Partners, a management and technology consultancy.
Assumptions that banks’ risk departments wielded the systems and the clout to effectively monitor their exposures to the trading activities of counterparties or staff have been blown apart in the last two years. Over-exposure to the US sub-prime mortgage market left many banks with crippling holes in their balance sheets. And the subsequent paralysis of the wholesale credit markets – during which some global banks could not secure anything more than overnight money – was in no small part the result of uncertainty about the long-term viability of counterparties, in the absence of hard data. Concerns about counterparty risk quickly spread to the buy-side, with many asset managers concentrating business at brokers with the smallest spreads on the credit default swap market.
Ponzo says many banks and brokers are now overhauling their risk management systems and processes to take account of both the global financial crisis and the slew of still-evolving regulatory initiatives that have followed it. He argues that the enterprise-wide approach to credit risk now being implemented is finally overcoming a silo-based mentality that can obscure overall exposure levels to counterparties. Exposures that arise in one asset class are now being fed quickly into overall risk calculations.
“The silos have not been knocked down necessarily,” says Ponzo, “but a layer has been constructed across them that can feed what is happening in a given asset class into a central risk aggregator in real time which then feeds back into the counterparty’s credit limit for the asset class in question.” He describes the shift from daily changes in credit limits to recalculations that take place in seconds or minutes as “a massive improvement”.
The practice of risk management has, of course, had to change conceptually as well as technologically to reflect the ever more complex relationships between firms operating in the financial markets. “As a bank, your exposure to a counterparty is not just a matter of the amount of trading you do with them; it might include the fact that you are facilitating a trade with a hedge fund that is building up a stake in that counterparty,” says Ponzo. Moreover, tales of over-cautious risk officers being sidelined or replaced are being replaced by reports of more sell-side firms following Goldman Sachs’ lead by nudging ambitious traders in the direction of the risk office as a necessary step on the path to senior management. As Ponzo observes, “Risk management is no longer a business prevention activity, it’s becoming an integral part of the decision-making process of trading.”
Formerly head of financial markets technology group NET2S, Ponzo left the firm late last year, after it was acquired by BT and plugged into the telecoms provider’s global financial services business. Launched in February, Grey Spark is a 20-strong, London-based outfit offering management and technology consultancy services to both buy- and sell-side institutions. In addition to Ponzo, founding partners include George Kao, formerly a sales executive in Barclays Capital’s Barx e-commerce business, and fellow NET2S alumni Andrew McLauglan and Bradley Wood. In an industry “saturated with generalists”, says Ponzo, Grey Spark’s USP is the creativity, experience and tenacity of its people. “Our consultants are adept at coming up with solutions and seeing them through,” he asserts. The firm will concentrate on the European market at first, but hopes to branch out to the US and Asia in due course.
In addition to reengineering their risk management practices, Ponzo notes that many sell-side firms are also investing in technology to further automate the trading process in asset classes beyond equities.
“So much emphasis has been placed on equities over the past four or five years, from an electronic trading perspective, that FX and fixed income have become neglected,” he says. “Now they are very important.” With equities trading volumes falling by half in many markets during 2009, the focus of both buy- and sell-side firms switched to other asset classes, with fixed income in particular being seen as safer territory, buoyed in part by new issuance.
Until recently however, fixed income has remained a largely quote-driven market in which the buy-side must submit requests for quotes to multiple sell-side firms to compare prices. Ponzo describes the current drive toward brokers providing firm, executable prices as “not quite a revolution, but a big step”, for credit. If, as Ponzo suspects, this leads to increased market transparency and opportunities for arbitrage, the accompanying reduction in spreads will be welcomed by the buy-side heads of trading whose remit has widened to included fixed income trading in recent years.
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