Just under two thirds of participants in November’s The TRADE poll believe that investment institutions have stiffened counterparty risk measures in the past year. While this may seem an appropriate response to increased volatility and an uncertain regulatory and macro-economic outlook, some industry experts were surprised the proportion wasn’t higher.
When asked in this month’s The TRADE Poll if buy-siders had increased their counterparty risk measures for brokers and trading venues in the last 12 months, 64% of readers were of the opinion that they had, while 36% felt that no material change in policy had taken place.
Steve Wood, founder of Global Buy Side Trading Consultants and former global head of trading at Schroder Investment Management, was surprised the numbers weren’t higher. “With the current crisis nearing a 2008 scenario, it should be closer to 90% of buy-siders tightening their counterparty risk measures,” he said.
Over the past three months, a number of issues have drawn the buy-side’s attention to the hidden risks seemingly solid counterparties can pose. A rogue trader at UBS caused the Swiss bank a US$2.3 billion loss. American futures broker MF Global collapsed after a $6.3 billion bad bet on European sovereign debt. Block trading venue operator and agency broker Pipeline failed to disclose that a high proportion of orders executed on behalf of buy-side customers in its US dark pool were filled by an affiliated trading firm.
“Buy-side firms need to more rigorously assess counterparty risk in the normal course of their risk analysis systems,” said Wood. “They must ask themselves, what is the counterparty risk matrix at their firm? It is good to say they will start looking at capitalisation but that is only the starting point. It is not the full story. The question is not just the intensity of the risk, but also the quality of the risk.”
Wood recommends all parts of the business, including traders, be involved in constructing the risk matrix. “This is not just a back-office process anymore,” he said.
And counterparty risk promises to become ever more complex. Steve Grob, director of group strategy at technology provider Fidessa, said buy-side customers will soon start to feel “venue fatigue” as more trading platforms begin to offer more diverse liquidity.
“The problem for fund managers trying to rebalance their portfolios will be that they will have to lift the lid on every pool of liquidity to see if their trade is on the other side,” said Grob. “This has implications for information leakage and extra cost.”
Grob believes to better manage counterparty risk, buy-siders may embark on a fundamental change in their best execution policies.
“The buy-side may begin to worry less about scouring for every little bit of liquidity and worry more about risk exposures,” Grob said. “They may choose not to include certain types of venues in their pool of providers.”
Grob added that counterparty risk needed to be front of mind in an environment which is currently “over-broked with brokers and venues”. Down the line, he believes consolidation seems inevitable as venues fight for survival. “There is regulatory and commercial pressure on the structure of the markets. New business models are developing. Some will work and some won’t. Managing counterparty risk in such an environment has added complexity and people should factor this in,” he said.