Buy-side risk projects set to increase in 2010

The recent Tabb Group study, The Buy Side Perspective on Risk: Frequency, Aggregation and Process, polled 110 long-only managers, hedge funds and proprietary trading firms over the course of 2009 on how these firms manage trading risk as well as their attitudes and approaches to enterprise risk management.

Across the board, the study found that respondents have increased their risk focus in the past year: 88% of large managers, 71% of mid-sized managers and 100% of small managers reported rises in the frequency and sophistication of their risk-related procedures and activities.

Tabb Group sees these concerns stemming from four key weaknesses among investment managers in terms of their risk management processes preceding the Lehman collapse - inaccurate analysis of expected volatility; underrated liquidity risk; the rise of counterparty risk; and operational risk related to Madoff-style Ponzi schemes, insider trading and other issues.

"The challenge is how to collect all the necessary data needed to address each of these four weaknesses," write report authors Adam Sussman and Alex Tabb. "This is not just about breaking any existing silos between asset classes and geographies. It also means detailing the risk the buy side is exposed to through bilateral agreements, securities lending, commission pools and even consumers (through front-end trading platforms and hosted services)."

IT, processes due for improvement

Tabb Group emphasises that efforts to improve buy-side risk management processes entail potentially complex, multi-front endeavours, and that single points of weakness can potentially undermine other more robust elements of a firm's risk controls.

When asked which components of their risk infrastructures they plan to improve in 2010, more than a third of respondents indicated technology as a key focus (see figure 1). Specific areas targeted include market risk monitoring, counterparty data, information security and disaster recovery capabilities.

But technology only goes so far when it comes to better risk management, caution Sussman and Tabb. More than 25% of respondents also indicated plans to overhaul their risk processes involving counterparty risk and operational controls prevention. To address counterparty risk issues, managers plan greater collaboration to prevent lack of data and inadequate co-ordination between departments. To improve operational controls, they plan to limit access and beef-up change-management monitoring.

As part of these risk management improvement efforts, more than half of managers taking part in the Tabb Group survey indicated they are already using third-party risk-monitoring tools or plan to implement such tools during 2010. This appears to be a significant change: less than a quarter of managers interviewed by Tabb Group since 2008 reported using third-party risk tools. Managers active in options trading used systems such as Derivix, MicroHedge and SuperDerivatives, while equity managers reported using products such as Thomson Reuters' JRisk and Barra Aegis. Currently 66% of respondents
use either proprietary risk-management tools or third-party provided applications, while, somewhat surprisingly, 17% continue to use Excel to support their risk management activities (see figure 2).

Greater risk dedications

Unsurprisingly, stronger data management is prescribed as a key treatment by Tabb Group to improve risk issues. Sussman and Tabb are clearly aware, however, how challenging data-related efforts can prove.

"The most successful risk-management operations are those that can see through different types of barriers, be they organisational, geographical, technological, or asset class," write the analysts. "Without a timely picture of positions and counterparty exposure, even a perfect risk model would fail."

Tabb Group analysts have found that data issues have been more effectively addressed recently at firms where risk offices have been made independent. Roughly half of all equity managers taking
part in the study reported now having a separate risk division active across fund structures and counterparty exposures.

Sussman and Tabb argue that more collaborative and distinct risk-management processes can particularly benefit counterparty and enterprise risk issues. Data aggregation has proven especially difficult for managers dealing with these risks, Sussman and Tabb write, because knowing one's total exposure to a counterparty requires knowing your direct investments, credit risk exposures to bilateral agreements and assets held in that counterparty's name (see figure 3).

Problems of course arise owing to poor or non-existent communication between the systems required to capture data pertaining to these various factors.
Buy-side managers now have a number of options available to address these enterprise and counterparty risk challenges: third-party data management solutions from the likes of GoldenSource, Asset Control, SunGard and Cadis; complex event processing technology to improve data aggregation; and counterparty data sources such as Broadridge, Interactive Data and CounterpartyLink. ><