A centralised database which reduces the time lag between the trading of an exotic derivative and its reconciliation, and gives a clearer picture of how that derivative is impacting an institution’s entire investment spectrum, will be crucial in the stricter regulatory environment ahead writes PETER HILL, the managing director of SimCorp Asia.
The current economic environment is extremely volatile. An early victim was the 85-year-old American investment bank, Bear Stearns. Signs of Bear’s troubles were visible early when some of their hedge funds, once regarded as ‘innovative’, were shut down due to huge losses from piles of debt assets with incomprehensible values.
Even though the warning signs were evident the damage had been done, the debts could not be unloaded and the once-venerable institution was on an unstoppable downward spiral. But Bear Stearns’ collapse, along with the devaluation of financial institutions worldwide, has brought to light the importance of evaluating and mitigating risk. As investment opportunities become more complex, so do the risk associated with them, and methods for accounting for such risk.
It is therefore crucial to have a system in place that can scale, accommodate complexity, and can be customised to audit and manage records according to regulatory, organisational and product specific criteria. One method of mitigating risk is through the use of derivatives to for example, balance a position in a pre-owned security, or to take a long or short position without being fully invested. Derivatives, whose intrinsic values are derived from an underlying asset, are heavily weighted on speculation in regards to the price of the underlying, and consequently their prices fluctuate wildly. Exotic derivatives, which add a layer or several layers of complexity to a plain vanilla derivative by taking into account various factors, such as volatility, or by incorporating more than one underlying security, can be especially difficult to monitor in terms of value and pricing.
Exotics can provide great value to traders by allowing them to take advantage of market inefficiencies and by dispersing financial risk across several fronts. However, managing them can be especially cumbersome and laden with operational risk. Therefore it is crucial that data within an organisation is consistent and easily and efficiently accessible. This allows for a reduction of the operational risk associated with data gathering, inputting and processing, and has the added benefit of increasing transparency as well as allowing for more accurate reporting of investment activity.
This becomes even more vital with the trading of exotic instruments and derivatives due to their inherent complexity. By processing instrument behaviour through a centralised database, operational risk associated with complexity and lack of visibility is minimised; and the observer, whether a portfolio manager, or tax accountant, can better understand what is actually happening to the instrument in question. Instead of reconciling information across numerous sources, any changes made to the holding can be quickly translated across the investment spectrum, so instruments can be evaluated in real time. In practice, implementation of a management and reporting system for exotic instruments can be especially difficult and time-consuming.
Traders may begin trading a new instrument without concern for the trade processing and accounting that needs to occur behind the scenes, and may be trading a new instrument for weeks, months, or even years before it is properly configured in the internal management and accounting system. Reducing the time gap between trading and reconciling the trade can go a long way to increasing visibility into the actual performance and values of the new instruments.
A single, centralised database where investment information is maintained not only leads to a reduction in operational risk, but also to an increase in operational efficiency. Removing the requirement to reconcile data across various fronts reduces the burden on human capital, and improves the synergy across the organisation’s infrastructure. While traders may not pay much attention to what is happening in the back office, a system that allows for straight-throughprocessing can drastically reduce the burden on those who do need to pay attention to superficial performance and risk as well as underlying monitoring and compliance.
When choosing investments themselves, each investment manager has its own criteria, and may be mandated to follow certain investment guidelines based on a prospectus, or investment goal. Due to the array of investment styles, investor risk tolerance and regulations, accounting for investment activity can vary greatly between different firms.
Technology, allowing for customisation for a fund type or investment objective, can make following investment guidelines, and reporting to the aforementioned parties, easier, more efficient and more reliable. As was the case after the series of high-profile failures in the ‘80s, government regulation and investor scrutiny resulted in a plethora of new rules and regulations intended to prevent risk adverse behaviour. Undoubtedly, new regulations and renewed scrutiny will emerge from the current credit crisis, dictating more transparency and visibility into investment managers’ investments and books.
Having a solution that can quickly adapt to meet newly crafted monitoring and reporting requirements will thus become even more important. In a changing regulatory environment, an adaptable and robust investment operations system becomes more attractive, as it can meet new guidelines faster than point solutions, which each have to individually be upgraded and configured to meet new requirements.
One of the lasting results of the current subprime fallout and credit crunch will be increased scrutiny and a heightened requirement for awareness of investment activity and risk from regulators, investors and corporate stakeholders. Investors, whether institutional or individual, will be putting more credence to risk, whether it is systematic or operational, and the riskiness of an investment will likely play a greater role in investment decisions.
At some point we will emerge from the current downturn, and institutions will once again infuse cash into new investments. But this time, proper investment standing and valuation will be both an internal as well as external requirement. Data that can be quickly, efficiently, and accurately maintained will increasingly become a requirement and not just a luxury.
It is important to be armed with the proper tools and the proper insight to stay abreast of changing conditions, and ensure you don’t lose.