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| Structured Products - Using EDM to Manage Risk |
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| Written by Neil Edelstein | |||||
| Sunday, 01 June 2008 | |||||
| Banking Technology | |||||
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At a time when the credit crunch is stifling liquidity and high-profile casualties such as Bear Stearns are making headlines, it is remarkable that the innovative and fast-moving market in structured products continues to grow unabated. Liquidity problems aside, products traded over the counter (OTC), as opposed to an exchange, will continue to be attractive because they allow the flexibility to customise price and expiration to fit investors' needs. Data recently released by data vendor Markit Group, revealed that trading volumes rose to near-peak levels of 25,000 trades per dealer for each of the first three months of 2008 with the average number of outstanding confirmations at around 7,000 per dealer per month. This is clearly a sign that operational efficiency in the credit derivatives market needs to improve if a major counterparty default with domino-style consequences is to be averted. This insight also shows that many institutions are largely unprepared for the pace of change and innovation in the current market. The historical need to maintain speed-to-market at virtually any cost has left institutions with a bewildering tangle of specialised systems. Each chosen as the fastest way to respond to the latest trend in the market, with no thought of how to handle instruments that cut across traditional silos of equities, fixed income, FX or commodities. Unlike exchange-traded products, OTC derivatives lack transparency and are particularly fraught with all manner of risks including counterparty, credit, market, settlement, etc. These risks are compounded as the derivative remains linked to the market risk of the underlying security. A siloed and fragmented approach to processing these assets means that most financial institutions cannot easily generate or maintain referential data for such derivatives, particularly since most have built up a tangle of back-office systems, each highly tailored to the specific requirements of a single product and offering little flexibility or scope for integration. From a strategic perspective, the lack of integration not only translates into higher cost of sales, but also makes it impossible to accurately assess risk and manage P&L at the level of the entire enterprise. In the current credit climate such risks are unsustainable. Structured products are designed to provide highly tailored hedges or synthetic exposure for both the market-maker and the client, and as such they tend to be both complex and bespoke. Institutions operating in the derivatives markets share the same key strategic goals: higher speed-to-market, better risk management, lower transaction costs and improved operational transparency, without introducing risk. To successfully manage these products, financial institutions need to be able to gain a clear view of all the facts associated with them: instruments, customers, counterparties, trades, positions – with a full understanding of how these facts are linked. Many institutions are now turning to a more integrated approach, untangling the mess of their legacy systems and transforming them into a more efficient cross-asset solution that can be quickly and efficiently referenced by many business units. This integration approach can be defined as Enterprise Data Management (EDM) in which all the critical data of every customer, security, and position, are centrally collected, stored and interlinked. EDM is based on the creation and maintenance of a central trusted golden copy of data, which includes wrappers that define and provide context for that data. This enables institutions to immediately see the connections between all categories of data, allowing rapid and accurate assessments of risk and profitability for even the most complex products. While, EDM has been widely adopted for vanilla financial products; the richness and flexibility of the data model also makes it ideally suited to the management of dynamic and complex derivatives with unequivocal links to their underlying securities. By improving transparency and enabling real-time roll-up of the position, EDM can significantly improve risk management. Building a new product – no matter how exotic – on a capable EDM platform immediately enables an institution to see all of the underlying links and dependencies, and to understand the credit risk across all components and counterparties for a particular product. EDM can also readily provide detailed insight into the profitability associated with any customer or instrument.
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