2011 Preview Part III – Risk Management

Risk management is arguably the most poorly defined business practice across the buy and sell side. This is not a criticism, just a fact of life. It is the umbrella term that can be used to cover a wide variety of operations - the three ‘traditional' disciplines of credit, market and operational risk, plus the more recent additions of counterparty and market liquidity risk - all of which tend to mean different things to different organizations.

But that doesn't mean risk isn't an important process to manage transparently and efficiently, a process likely to garner significant attention from investors and regulators alike during the year ahead.

The prediction that risk management will be on everyone's mind during 2011 is unlikely to earn me the epithet of industry clairvoyant - that's a given, but what isn't clear is which areas of risk management will be the most prominent for the next 12 months. Here's my take:

1. Enterprise risk management (ERM) will continue to grow in popularity, especially for second-tier firms, who, until recently, didn't have the wherewithal to even begin contemplating managing their risk in a holistic manner. But generating a single, enterprise-wise VaR (value-at-risk) number embracing all business lines, counterparties, geographies and markets at a given time, is no mean feat. And, as is the case with so many other complex business processes throughout the financial services industry, enterprise risk management is contingent upon the accuracy, consistency and cleanliness of a firm's market and reference data. ERM, therefore, is as much a data management issue as it is a risk management one.

2. Market liquidity risk management - the risk of losing money in the event of liquidating one or more positions in a portfolio - is a buy-side-specific risk management concern. Until recently, replicating bid, ask and volume data for bonds and OTC derivatives was an acute challenge even for the most sophisticated buy-side players, but thanks to enhancements to StatPro's recently launched version 5.70 of its StatPro Risk Management (SRM) platform, there is a glimmer of light at the end of this tunnel. This is not a shameless plug for StatPro's technology, but rather an acknowledgement that finally there is progress on the market liquidity risk management front.

3. Real-time risk management is something of a misnomer in the sense that it refers more to real-time compliance than extrapolating specific risk measures on a pre-trade basis. In other words, this is not so much about pre-trade stress tests and Monte Carlo simulations, but more about pre-trade limit checks, counterparty checks and compliance according to specific client mandates. Even so, managing such checks in real time will become increasingly common across the buy and sell side during 2011, even for high-frequency trading shops.

4. OTC derivatives processing will, during 2011, become a key consideration for market participants, signaling risk management's move from the front and middle office to the back office, responsible for managing affirmations and confirmations - ideally on an intra-day basis so as to reduce failure rates and increase the likelihood of settlement occurring - and allocations of collateral or capital for such instruments. This may not be the sexiest part of this industry, but boy is it important. And, as with ERM, data management considerations should not be underestimated with any process designed to automate what has until recently been a manually intensive, and therefore woefully inefficient, process.