CROSSINGS The Journal of Trading and Management

Edition Three: Summer 2010 CROSSINGS: The Journal of Trading & 2 TABLE OF CONTENTS

Introduction: The Journal of Trading and Risk Management ...... 3 by Chip Register

Editor: comments ...... 5 by Jonathan Davies

U.S. Financial Reform: overview and industry implications ...... 7 by Chris Ekonomidis and Ryan Baccus

OTC Derivatives: the evolution of market infrastructure ...... 12 by Bill Hodgson and Ryan Baccus

Loan Trading: market reform ...... 17 by Bernadette Conway and Karl Page

Insurance: risk, regulation, and the path to Solvency II ...... 21 by Winn Faria and Paul Saunders

Regulatory Shifts and Lessons for Risk Management: an interview with Dynegy’s Rudi Zipter ...... 28

Asset Management Technology and Process: alignment and HYROXWLRQWRZDUGFURVVDVVHWRSHUDWLRQDOHI¿FLHQF\ 32 by Mark Israel and Sean Smillie

OMS Evaluation: accommodating asset managers’ evolving needs ...... 37 by Kevin Masso and Anurag Mathur

OTC Derivatives Valuation: adoption of multiple pricing curves ...... 43 by Kevin Samborn

Energy Risk Management: toward a consistent approach ...... 49 by Tony West and Sunilkumar Ramakrishnan

1 CROSSINGS: The Journal of Trading & Risk Management 2 INTRODUCTION: The Journal of Trading and Risk Management

At the end of May 2010, just as we were going and unforeseen consequences, so managing the of to print this edition of Crossings, the United implementation will require a pragmatic and cautious approach, combined with a very deep understanding of the 6WDWHV6HQDWHSDVVHGLWVYHUVLRQRI¿QDQFLDO mechanics of these markets, if we are to avoid “poisoning UHIRUP OHJLVODWLRQ This bill will now head into the patient.” conference to be merged with the version passed in the United States House of Representatives last November, :HKRSH\RX¿QGWKHDUWLFOHVLQWKLVHGLWLRQRI&URVVLQJV ZLWKWKHH[SHFWDWLRQWKDWWKHUHZLOOEHD¿QDOELOOSURGXFHG topical, insightful, and useful, as we all learn to navigate and on the President’s desk for signature by July 4th. It the future regulatory landscape. We will, of course, stay is no coincidence that a majority of the topics covered in on top of these topics as they develop and post further this edition are dedicated to the review and commentary of information on our website (www.sapientglobalmarkets. pending reforms, as well as potential future-state market com) from regulatory, technology, and operations points structures. The reason for our interest, not surprisingly, is of view. purely the scale and ambition of the overhaul. Not only are

ZHQRWTXLWHVXUHZKDWZLOOZLQGXSLQWKH¿QDOYHUVLRQRI Best Regards, the law, but no one really understands what all this will mean to the markets in terms of their liquidity and safe operation—not to mention infrastructural requirements and regulatory frameworks. It is, bar none, the largest ¿QDQFLDO UHIRUP OHJLVODWLRQ VLQFH WKH *UHDW 'HSUHVVLRQ and its implications are considerable, but largely unknown, Chip Register and will remain that way until the legislation is signed Senior Vice President and Managing Director into law. Sapient Global Markets [email protected]

Clearly, some of the most interesting aspects to readers will be the operations and mandates of the new Financial Stability Oversight Council. The council is charged with “monitoring and addressing” system-wide risks; how dealers, exchanges, and clearing houses will respond to mandates to trade more over those platforms as opposed to carrying large bi-lateral portfolios; the effect of higher capital requirements on liquidity; and whether banks will be required to spin off their derivatives units entirely and potentially close proprietary trading activities altogether (as is suggested in the House version in the form of the Volcker Rule). Any one of these changes could have large

3 CROSSINGS: The Journal of Trading & Risk Management 4 EDITOR comments

7KH ¿QDQFLDO EDLORXW RI EDQNV E\ JRYHUQ single technology platform that processes all trades across PHQWV DQG KHQFH WD[SD\HUV KDV JLYHQ asset classes. Kevin Masso and Anurag Mathur add to this SROLWLFLDQVWKHDPPXQLWLRQWRGULYHWKURXJK technology discussion by outlining key considerations for UHJXODWRU\ FKDQJH :KLOH PDQ\ EDQNV KDYH upgrades or new implementations of Order Management DOUHDG\ UHWXUQHG WR SUR¿WDELOLW\ DQG VRPH Systems. Kevin Samborn investigates a remarkable new KDYHHYHQSDLGEDFNEDLORXWIXQGVUHJXODWRUV development in the derivatives market with regards to DQG SROLWLFLDQV DFURVV WKH JOREH VWLOO VHHP KRZVZDSFXUYHVDUHYDOXHG$QGLQRXU¿QDODUWLFOH7RQ\ LQWHQWRQUHIRUP As such, the focus of the Summer West and Sunilkumar Ramakrishnan write on how energy 2010 edition of Crossings is on the regulatory reforms trading companies are becoming more sophisticated in proposed in Europe and the U.S. and the effect that these the way that they manage risk. regulations may have on our clients’ businesses. In reviewing all of these articles, it is clear that whether ,Q RXU ¿UVW DUWLFOH &KULV (NRQRPLGLV DQG 5\DQ %DFFXV you are involved in , insurance, energy VKHGOLJKWRQWKHFRPPLWWHHVDQGLQÀXHQFHUVLQYROYHGLQ trading, or investment banking, regulatory reform will U.S. Financial Services regulation. Bill Hodgson and Ryan drive increased automation and transparency. The Baccus highlight how far the infrastructure of the OTC reforms are likely to provide an impetus for many of our derivatives market has evolved over the past four years clients to better manage and understand their risks. The to become more automated and discuss how some of the short-term effects of this improvement could be reduced new market developments will address the regulators’ market liquidity and costly implementation projects, concerns regarding transparency. Bernadette Conway and while the strategic long-term outcome could be improved Karl Page look at how some of the regulatory reforms in risk management. It is important, however, that the the U.S. and Europe will affect the trading of loans. And, industries do not become over-regulated—with the cost to to complete our analysis of how potential regulation may implement regulations driving key institutions out of the affect various industries, Winn Faria and Paul Saunders capital and commodities markets. discuss the effect of Solvency II on the insurance sector. I am pleased to present, and trust that you will enjoy, this Next, one of our clients offers his unique insights on the third edition of Crossings. WULFNOHGRZQHIIHFWWKDWSHQGLQJ¿QDQFLDOPDUNHWUHIRUPV may have on banking counterparties. Rudi Zipter, Vice President of Commercial Trading at Dynegy, a leader in the energy sector, talks about the challenges of new reporting requirements and how organizations can be Jonathan Davies better prepared to meet them. Editor [email protected] 7KH ¿QDO IRXU DUWLFOHV LQ WKLV HGLWLRQ RI &URVVLQJV ORRN at market developments in the asset management, derivatives, and commodity sectors. Mark Israel and Sean Smillie discuss how asset managers are moving toward a

5 CROSSINGS: The Journal of Trading & Risk Management 6 U.S. FINANCIAL REFORM: overview and industry implications

Global regulators are drawing up numerous reform proposals for financial institutions and Over-the-Counter (OTC) derivatives trading. While these changes range from increasing trade transparency to deciding which entity is best able to regulate, one thing is certain—change is coming. Chris Ekonomidis and Ryan Baccus discuss how some of the recent announcements in the United States may affect U.S.-regulated financial institutions.

The United States legislature is currently debating the &KDPEOLVV 5*$  DV WKH UDQNLQJ 5HSXEOLFDQ  DQG WKH IXWXUH RI ¿QDQFLDO VHUYLFHV UHJXODWLRQ LQ DQ HIIRUW WR Banking, Housing, and Urban Affairs Committee (chaired prevent such events as the industry bailout and failure by Sen. Christopher Dodd (D-CT) with Sen. Richard of Lehman Brothers from reoccurring. Congress has Shelby (R-AL) as the ranking member) were the two outlined several methods to achieve these goals and steps committees involved in the debate. have already been taken down the path of reform. In addition to the aforementioned committees, other LQÀXHQFHUV UHJDUGLQJ ¿QDQFLDO VHUYLFHV UHJXODWLRQ The United States Regulatory Structure include members of such agencies and departments The U.S. Congress is composed of two houses, the House DV 7LPRWK\ *HLWKQHU 6HFUHWDU\ RI WKH 7UHDVXU\ %HQ of Representatives (House) and the Senate and a bill may %HUQDNH &KDLUPDQ RI WKH %RDUG RI *RYHUQRUV RI WKH be introduced by a member of Congress in either house. Federal Reserve Board (FRB); Mary Schapiro, Chairman For example, a bill introduced by a member of the House of the Securities and Exchange Commission (SEC); goes through a committee review and then passes to the *DU\ *HQVOHU &KDLUPDQ RI WKH &RPPRGLW\ )XWXUHV full House for additional amendments and, possibly, a Trading Commission (CFTC); Sheila Bair, Chairman of vote. Next, the other house, in this case, the Senate, takes the Federal Deposit Insurance Corporation (FDIC); and the House’s bill, or their own version of the bill, into Paul Volcker, Chairman of the President’s Economic committee for consideration. This Senate bill follows a Recovery Advisory Board. similar path before being reported to the full Senate for a vote. Since House and Senate bills are rarely exact copies of each other, the passed versions must be reconciled before Recent Legislation being voted upon by the full House and Senate. Only then As previously mentioned, the House of Representatives LVWKH¿QDOSDVVHGELOOEURXJKWEHIRUHWKH3UHVLGHQWIRU passed the Wall Street Reform and Consumer Protection signature into law. Act of 2009 (H.R. 4173) in December 2009. Highlights from the House bill include: For example, the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) passed both houses of )LQDQFLDO6WDELOLW\DQG6XSHUYLVLRQZKLFK Congress in December 2009. This bill passed the House Establishes a Financial Stability Council, an inter- with a vote of 223-202 after consideration by the House’s agency oversight council, to systemically identify Financial Services Committee (chaired by Rep. Barney ULVN\ ¿QDQFLDO ¿UPV DQG VXEMHFW WKHP WR KHLJKWHQHG Frank (D-MA) and ranking minority leader Rep. Spencer oversight and regulation Bachus (R-AL)) and the Agriculture Committee (chaired Establishes dissolution authority to provide an orderly by Rep. Collin Peterson (D-MN) and ranking minority process for winding down failing institutions and limit leader, Rep. Frank Lucas (R-OK)). Within the Senate, LPSDFWVRQWKHEURDGHU¿QDQFLDOV\VWHP the Agriculture, Nutrition, and Forestry Committee (chaired by Sen. Blanche Lincoln (D-AR) with Sen. Saxby

7 PRESIDENT

Barack Obama

CONGRESS REGULATORY AGENCIES

HOUSE OF Economic SENATE Federal Treasury REPRESENTATIVES CFTC SEC FDIC Recovery (S. 3217) Reserve Secretary (H.R. 4173) Advisory Bd

Gary Mary Sheila Ben Tim Paul Agriculture, Nutrition Gensler Schapiro Bair Bernanke Geithner Volcker Financial Services Cmte and Forestry Cmte 1 Blanche Barney 2 Lincoln 4 Frank

Saxby Spencer Chambliss Bachus

Proposals to fix the financial markets Banking, Housing & Agriculture Cmte Urban Affairs Cmte

Chris 5 Collin 3 Dodd Peterson

Richard Frank Shelby Lucas

Approved: 13 to 10 Approved: 223 to 202

Figure 1: Committees and Influencers Involved with U.S. Financial Services Regulation

'HULYDWLYHV5HIRUPWR The Senate is debating S. 3217, the Restoring American Regulate the OTC derivatives market by forcing Financial Stability Act of 2010. There are some similarities standardized swaps between dealers and “major with the House version but there are also some noticeable participants” to be cleared and traded on exchanges differences. Highlights of the Senate’s 1,700+ page bill include: ,QYHVWRU3URWHFWLRQ0HDVXUHVZKLFK 5HIRUP FUHGLW UDWLQJ DJHQFLHV WR UHGXFH FRQÀLFWV RI )LQDQFLDO6WDELOLW\DQG6XSHUYLVLRQ interest, reduce market reliance, and impose a liability Establishing a Financial Stability Oversight Council, standard chaired by the Secretary of the Treasury with membership consisting of leaders of the Board of Improve investor protection by strengthening the *RYHUQRUVRIWKH)5%WKH2I¿FHRIWKH&RPSWUROOHURI SEC’s power to regulate the securities markets the Currency (OCC), the Bureau, the Federal Housing Reform compensation structures to discourage short- Finance Agency, the Chairs of the SEC, FDIC, and CFTC, term incentives that may encourage excessive risk- and a presidential appointee, to address systemic risks taking ZLWKLQWKH¿QDQFLDOV\VWHP Imposing enhanced prudential standards on 3ULYDWH)XQG5HJLVWUDWLRQZKLFK systemically important Bank Holding Companies Requires registration of funds and private equity %+&V  DQG QRQEDQN ¿QDQFLDO FRPSDQLHV LQFOXGLQJ ¿UPVZLWKWKH6(& requirements on risk-based capital, leverage ratios, liquidity, and concentration limits &RQVXPHU3URWHFWLRQZKLFK Establishes a Consumer Financial Protection Agency $XWKRUL]LQJ RUGHUO\ OLTXLGDWLRQV RI ¿UPV WR OLPLW (CFPA) to protect consumers from unfair and abusive EURDGHULPSDFWVRQWKH¿QDQFLDOV\VWHP SUDFWLFHVDFURVVDZLGHUDQJHRI¿QDQFLDOSURGXFWVDQG Redistributing powers between the FRB, OCC, and services )',&²WKHELOOVSHFL¿FDOO\DEROLVKHVWKH2I¿FHRI7KULIW Supervision (OTS) and transfers powers to the OCC

CROSSINGS: The Journal of Trading & Risk Management 8 Limiting merger and acquisition activities for &RQVXPHU3URWHFWLRQ V\VWHPLFDOO\LPSRUWDQW¿QDQFLDOFRPSDQLHVDQG%+&V Establishing a Bureau of Consumer Financial Protection with over USD $50 billion in assets (Bureau) within the Federal Reserve System to regulate FRQVXPHU¿QDQFLDOSURGXFWVDQGVHUYLFHV $OORZLQJEUHDNXSVRIV\VWHPLFDOO\LPSRUWDQW¿QDQFLDO FRPSDQLHV LI WKH\ SRVH D ³JUDYH WKUHDW´ WR ¿QDQFLDO stability Possible Industry Implications Prohibiting insured depository institutions, BHCs, The ultimate goal of the reform legislation is to reduce and their subsidiaries from prop trading and making systemic risks and increase market stability by lessening investments in hedge or private equity funds (Volcker the impact of market dislocations. Although it is not Rule) currently clear what form the passed legislation will take, LWLVDSSDUHQWWKDWLWZLOOKDYHDPDMRULQÀXHQFHRQWKHZD\ 'HULYDWLYHV $VVHW%DFNHG 6HFXULWLHV $%6  DQG business is performed and on the operations supporting &ROODWHUDO5HIRUP the business. Requiring central swaps clearing on an exchange or alternate swap execution facility for most transactions For example, regulation will force increased market Requiring that non-cleared swaps be submitted to a transparency by migrating derivatives trading to exchanges swaps repository and reporting to the SEC/CFTC RU DOWHUQDWH IDFLOLWLHV 7KLV SURFHVV ZLOO LPSDFW SUR¿WV RQ each trade as the bid/offer spread narrows and more capital Imposing new product approval by the SEC or CFTC, investment is required in operations and technology systems depending on the underlying asset, and requiring to accommodate the new requirements. The increase arbitration for jurisdictional resolution LQ DXWRPDWLRQ DFURVV ¿QDQFLDO LQVWLWXWLRQV H[FKDQJHV Requiring collateral and for dealers and regulators, and new derivatives repositories will improve major participants for swaps with higher collateral liquidity and increase trade volumes for standard contracts. requirements than non-cleared swaps Consumers may see a rise in prices if exchange trading of derivatives requires increased capital requirements from Requiring securitizers of ABS to retain 5% (by default) end-user companies for hedging activities. Higher costs of the for sold or transferred products and of doing business are always ultimately transferred to the prohibiting the hedging of the retained credit risk consumer. ([SDQGLQJ WKH GH¿QLWLRQ RI FRYHUHG WUDQVDFWLRQV ZLWK DI¿OLDWHV 6HFWLRQ $ RI WKH )HGHUDO 5HVHUYH Two of the most discussed changes are the Volcker Rule and Act) to include SEC lending activities and derivative the ban on swaps desks introduced by Sen. Lincoln within transactions, and requiring the appropriate collateral the Agriculture Committee. The Volcker Rule seeks to ban to be held for these transactions proprietary trading at banks and would require the closure of entire business units. Likewise, the original Lincoln 5HTXLULQJEDQNVWRVSLQRIIVZDSVGHVNVLQWRDI¿OLDWHV proposal to divest swaps desks seems to have evolved to (revised Sen. Lincoln amendment) allowing them to remain with banks—but they will need to EHSODFHGZLWKLQDQDI¿OLDWH ,QYHVWRU3URWHFWLRQ0HDVXUHV Reforming credit rating agencies’ accountability, The measure to introduce oversight and new product FRQÀLFWVRILQWHUHVWDQGDQQXDO6(&H[DPLQDWLRQV supervision of derivatives by both the SEC and CFTC, Reviewing executive compensation and additional depending on the primary underlying assets, may cause clawback provisions some confusion in the short term. To address these concerns, an arbitration approach has been offered, but +HGJH)XQG5HJLVWUDWLRQ WKH HI¿FDF\ RI WKLV UHYLHZ IXQFWLRQ ZLOO GHSHQG KHDYLO\ Requiring registration of hedge funds only (Senate), RQ WKH GHWDLOV )RU ¿QDQFLDO ¿UPV XQGHUVWDQGLQJ WKH but not private equity funds like House delineation between the two regulators’ jurisdictions within trading environments may require some ramp-up time.

9 Also, the extent and details associated with new product Expected Timelines DSSURYDOVPD\OLPLWWKHVSHHGZLWKZKLFK¿UPVFDQJRWR 7KHFKDQFHVWKDWWKH¿QDOOHJLVODWLRQZLOOH[DFWO\PLUURU market when introducing a new instrument. the above points are slim, but the similarities between the House and Senate bills are unmistakable. Public sentiment Margin and collateral requirements will increase as a RYHUWKH¿QDQFLDOLQGXVWU\¶VUHFHQWLPSDFWRQWKHRYHUDOO result of the requirement to trade derivative products economy is driving politicians to push for a meaningful on exchanges. In addition, non-cleared derivatives will YHUVLRQRI¿QDQFLDOUHIRUP7KHWZRSDUWLHVDUHZRUNLQJ require “substantially higher” collateral requirements to to reach consensus on key issues. account for their increased risk. The need to retain risk for a percentage of issued securitized products will also During April 2010, the Senate Agriculture Committee LPSDFW¿UPV¶DELOLWLHVWRHIIHFWLYHO\PDQDJHDQGRSWLPL]H passed an amendment that would have required banks to their capital. System upgrades will be required to automate divest the vast majority of their swaps operations. This led the integration of these new requirements and pass this to push back from the broader Republican Party and the information along to downstream systems (P&L, reporting, ¿QDQFLDOLQGXVWU\ZKRZHUHKRSLQJWRSUHYHQWOHJLVODWLRQ WUHDVXU\ HWF  3XWWLQJ WKH VZDSV GHVN ZLWKLQ DQ DI¿OLDWH that extended past the administration’s proposed reforms. ZLOODOVRUHTXLUHWKH¿QDQFLDOLQVWLWXWLRQWRKROGFROODWHUDO To date, Republicans were successful in delaying the against those trades and securities lending activities, per progression of the bill out of committee until they reach a the 23A changes outlined within the existing Senate bill. compromise on the key issues.

The changes previously mentioned to investor protection Still, Congressional members from both houses will begin will most likely limit the effects to credit ratings agencies campaigning for reelection in November 2010 and a need and the downstream systems used to consume this data. H[LVWV IRU HOHFWHG RI¿FLDOV WR SURYLGH WKHLU FRQVWLWXHQWV Compensation and clawback provisions will affect human with proof that their voices have been heard and that they resourcing systems and introduce additional levels of are implementing meaningful reform. The bill is being complexity around tracking compensation over longer time debated and amended in the Senate and then needs to be horizons. voted upon. Afterwards, reconciliation of the House and Senate versions of the bill will be necessary before it goes Registration of hedge funds and advisors seems to be to the President for his signature. Rep. Frank and Rep. LQHYLWDEOH EXW WKH ¿QDO GHWHUPLQDWLRQ RQ ZKHWKHU WR Bachus will most likely play prominent roles throughout LQFOXGHSULYDWHHTXLW\¿UPVZLOOPRVWOLNHO\EHDGGUHVVHG UHFRQFLOLDWLRQ *LYHQ WKH OHJLVODWLYH SURFHGXUHV DQG ZLWKLQUHFRQFLOLDWLRQ7KHNH\WHUPLQRORJ\PXVWEHGH¿QHG accounting for re-election campaigns later this year, a in order to understand the requirements and identify which reasonable estimate for passage is late summer 2010. ¿UPVZLOOQRWEHDIIHFWHG HJYHQWXUHFDSLWDO DVZHOODV After signature, the details of the changes that became the end-user exemptions for companies that do not pose a law need to be developed within the various agencies . and timetables will be established for implementation. The scope and breadth of these changes likely place &RQVXPHU SURWHFWLRQ SURYLVLRQV ZLOO IRFXV RQ ¿QDQFLDO LPSOHPHQWDWLRQGHDGOLQHVLQIRU¿UPV¶RSHUDWLRQVWR products offered to consumers to ensure they are comply with the new legislation. appropriate. These will likely have the most direct impact on retail sales and operations. Regulators have already begun TXHVWLRQLQJ¿UPV¶VDOHVWRLQVWLWXWLRQDOLQYHVWRUVDQGWKHUH is every reason to expect increased scrutiny of the products sold to retail customers. Firms already have to comply with suitability mandates, but this renewed emphasis may increase the need for automation and integration of content management systems and data warehouses in order to generate the necessary audit trails.

CROSSINGS: The Journal of Trading & Risk Management 10 International Regulation Chris Ekonomidis International regulatory cooperation is something that is a NY-based Senior Manager with regulators globally strive to achieve. In the OTC world, fifteen years of experience helping although the FRB has driven improvements in OTC clients leverage existing and new technologies to address compliance GHULYDWLYHV WUDGH SURFHVVLQJ RYHU WKH SDVW ¿YH \HDUV DOO needs, improve process efficiencies, of the global regulators have supported the initiative. reduce operational and regulatory The recent U.S. legislative debate may prompt the risks, and enable strategic business European Commission to update the policy actions they strategies. Prior to Sapient, Chris last communicated in late 2009, and already there are focused on compliance and risk discussions on the harmonization of hedge fund legislation solutions at Ernst & Young. [email protected] in the EU and U.S. with reciprocity between jurisdictions.

There is, however, a concern that the speed of new reforms and some differences of opinion among the U.S., Europe, Ryan Baccus is a Director based in London with and Asia, will inevitably lead to a new opportunity for extensive derivatives experience. regulatory arbitrage and, as such, a new generation of Ryan currently serves as the structured trades. With U.S. and International Accounting Program Manager for the DTCC Standards Board (IASB) accounting standards on fair Project Management Office (PMO) value also diverging over recent months, there may be to regulate the OTC Derivatives accounting arbitrage as well. standardization and automation of straight through processing (STP). [email protected]

Anticipating and Preparing for Change Regardless of the changes that are eventually signed into ODZ¿QDQFLDO¿UPVIDFHDQXSKLOOFOLPEWRSUHSDUHWKHLU employees and systems for the pending updates.

Throughout the coming months, effective risk management DQG SURFHVV HI¿FLHQFLHV DUH FOHDUO\ WKH UHJXODWRUV¶ IRFXV market participants who address these issues sooner rather than later will be the ones most likely to succeed. Firms should begin to anticipate legislation once it becomes more VROLGL¿HG 7KH FRPSDQLHV WKDW VWULNH D EDODQFH EHWZHHQ action and timing will be well poised to comply with their regulatory mandates, while taking advantage the unique market opportunities presented by this time in history.

11 OTC DERIVATIVES: the evolution of market infrastructure

The infrastructure for the Over-the-Counter (OTC) market has evolved rapidly of late. From early metric reporting in 2006 to the new regulations, development of Central Counter Parties (CCPs), and the introduction of MarkitSERV, the infrastructure has dramatically changed. Bill Hodgson and Ryan Baccus discuss the current OTC landscape and challenges users will face with new platforms.

The OTC processing environment has completed two The OTC Processing Landscape major phases over the past four years and it is now A wide range of companies provide software and services HQWHULQJDWKLUG7KH¿UVWSKDVHODVWLQJXQWLOFRXOG for OTC products; some cover multiple asset classes and be characterized as intermediate levels of automation and some specialize in a single product category. high levels of paper-based processing. The second phase, IURP  RQZDUGV OHG E\ 7LPRWK\ *HLWKQHU 8QLWHG The total notional outstanding value of a typical OTC States Secretary of the Treasury, opened a dialogue with contract gives an indication of the amount of trades in that Tier 1 dealers engaging them in a program of measurement, asset class, but not the actual represented. action, and improvement on key challenges in the Despite the rates market having by far the highest volume PLGGOHRI¿FHDQGEDFNRI¿FH7KHWKLUGSKDVHFXUUHQWO\ of business, the greatest investment in automation underway, is in a developmental stage where there is has been in credit derivatives, starting in 2005 (as a possibility that the United States Congress and the mentioned above). European Commission will introduce dramatic changes in the way the OTC market is regulated and require greatly increased use of Central Counter Parties (CCPs).

TOTAL CLASS PRODUCTS NOTIONAL $trillions

Interest Rate Swaps, Swaptions, Caps, Rates $436 Floors, FRAs, Currency Swaps

FX FX Options, Vanilla or Complex $48

Credit Credit Default Swaps (Single Name, $36 Index), CDOs, CLNs

Equity Options & Swaps, Total Return Equities $6 Swaps, Variance Swaps

Commodities Swaps, Options, and Forwards $3

Source: BIS Quarterly Review March 2010

Figure 1: Typical OTC-traded Contracts

CROSSINGS: The Journal of Trading & Risk Management 12 ISDA OTC ASSET CLASS

Credit Rates Equities FX Commodities

Trading Bloomberg, Reuters, , CreditEx, MarketAxess, Brokers (such as ICAP, Tullet, GFI etc.), ICE, CME, also phone based bilateral execution

eConfirm, Capture & MarkitSERV, TradeWeb, Bloomberg VCON, SWIFT Accord, ICE Link, Clearport Clearport, Confirm EFETNet

Warehouse DTCC TIW

Repository DTCC TriOptima DTCC & Markit

Portfolio TriOptima, Markit Reduction

Clearing LCH, Clearnet, ICE, CME, ICE, CME IDCG, Eurex, LIFFE

Central CLS Bank CLS Bank Settlement

Collateral & Markit, Lombard, Omgeo, Euroclear, TriOptima Portfolio Recon

Valuations CMA, SuperDerivatives, Markit, others

Third Party GlobeOp, State Street, Northern Trust, Brown Brothers Harriman, Administration BNY Mellon, JP Morgan, many others

Figure 2: OTC Service Providers

Trading &DSWXUHDQG&RQ¿UPDWLRQ International Swaps & Derivatives Association (ISDA) OTC 2QFHDWUDGHLVH[HFXWHGLWPXVWUHDFKDOHJDOO\³FRQ¿UPHG´ products are traded bilaterally, on a one-to-one basis and state as rapidly as possible to ensure that all parties have do not use an exchange platform where trades are executed an accurate record of the terms of the trade and, therefore, with a common central price. Many vendors provide the risk position they are managing. If the trade is executed D EURNHUDJH VHUYLFH WR ¿QG D SULFH DQG D FRXQWHUSDUW\ on an electronic platform, some or all of the terms of the for a trade, either using electronic tools, such as ICAP, WUDGHDUHDOUHDG\FDSWXUHGDQGHQDEOHUDSLGFRQ¿UPDWLRQ or the telephone. TradeWeb, CreditEx, MarketAxess, 7KH PDLQ FRQ¿UPDWLRQV SURYLGHU LQ FUHGLW UDWHV DQG Bloomberg, and Reuters also offer electronic platforms equities is MarkitSERV, the joint venture between Markit for price discovery and trade execution with varying and Depository Trust Clearing Corporation (DTCC), which levels of integration with the underlying processing contains the combined people and assets of what were services. The trading space has had incremental change IRUPHUO\6ZDSV:LUHDQGWKH'HULY6(59FRQ¿UPDWLRQV RYHU WKH \HDUV FRPSDUHG WR WKH EDFNRI¿FH VSDFH DQG platform. SWIFT also operates the Accord service, which has responded to the underlying infrastructure changes FRQ¿UPV )RUHLJQ ([FKDQJH );  RSWLRQV DQG LQ WKH relatively smoothly. commodities space IntercontinentalExchange (ICE) and the Chicago Mercantile Exchange (CME) provide end-to- end processing for trades executed on their platforms.

13 Warehouse Portfolio Reduction The ongoing dialogue between the Federal Reserve Bank TriOptima has led the way with mechanisms to reduce of New York (FRBNY) and the ISDA Operations Steering the number of OTC contracts held by parties, reducing Committee (OSC) created the pressure to clean up the processing costs. Holding OTC contracts to maturity, recordkeeping and payment calculation problems in the HVSHFLDOO\ ZKHQ WUDGHV FDQ UXQ IURP ¿YH WR  \HDUV credit space. As a result, DTCC launched a unique service carries a high annual cost of maintenance and can be called the Trade Information Warehouse (TIW), which avoided by removing “unnecessary” trades. TriOptima provides a legal primacy of the “golden” copy of the trade invented an algorithm that analyzes a set of trades details held by DTCC and fully standardized payment SURYLGHG E\ SDUWLFLSDQWV ¿QGLQJ WUDGHV WKDW UHSUHVHQW calculations for the lifecycle of trades. common risk between parties, which can be fully or partially terminated, leaving the overall risk exposure 3ULRU WR 7,: ¿UPV IRXQG LW GLI¿FXOW WR NHHS WKHLU RZQ between parties minimally changed. records synchronized with their counterparties. Should a company go bankrupt, a chaotic situation could result Clearing ZLWK¿UPVGLVDJUHHLQJRYHUZKRZDVDQGZDVQRWSDUW\ Central Clearing, or CCP, is the hot topic of the moment. to a trade. Additionally, there were differences on how Politicians in the U.S. and EU believe that, by moving the ¿UPVFDOFXODWHGWKHFUHGLWGHULYDWLYHFRQWUDFWSD\PHQWV OTC market into centralized clearing, they will prevent ZKLFKFDXVHGVHWWOHPHQWEUHDNVDQGEDFNRI¿FHH[SHQVHV DQRWKHU ¿QDQFLDO FULVLV OLNH WKH RQH LQ  $V VXFK to clean up the errors. many vendors have taken this opportunity to create new clearing services, including ICE, CME, Eurex, and LCH. At the moment, business drivers for creating a similar Clearnet for credit products. Membership in each CCP TIW in other asset classes do not exist, as each asset class is limited by criteria that generally allow only the largest has unique processing needs due to the nature of the DQG DOOHJHGO\ VDIHVW ¿UPV WR MRLQ GLUHFWO\ 2WKHU ¿UPV contracts. In addition, the expansion of clearing houses must clear trades through a direct member in a similar moving into the OTC derivative space changes the drivers model to the futures market. This model is still very new; for investment by also providing centralized lifecycle major dealers continue to build out their capabilities and processing of contracts. persuade the buy side to join clearing in advance of any new regulations. Repository $QRWKHU RXWFRPH RI WKH JOREDO ¿QDQFLDO FULVLV ZDV D Central Settlement realization that, in the event of a default, there is no After the development of the DTCC TIW, the processing central place to discover the portfolio of OTC contracts chain was completed with the seamless integration of RWKHUWKDQD¿UP¶VRZQLQWHUQDOV\VWHPV,QRWKHUPDUNHWV the CLS Bank settlement service and the TIW. CLS can such as equities, bonds, and exchange-traded products, accept and settle bilaterally netted payment instructions WKHUHFRUGVRIDQ\¿UP¶VSRVLWLRQVDUHKHOGE\DFHQWUDO direct from DTCC, as a result of the trades being fully processing service. With no central place to record OTC automated in the Warehouse. At the moment, only CLS trades, and a continued reliance on the systems within has authorization to process payments in the credit a bankrupt entity, the industry decided to create central derivatives market, and may, one day (based on demand), trade repositories to hold a list of contracts by all parties move into rates or equities. CLS Bank’s main business is in the OTC markets. ISDA ran a series of Requests for WKH VHWWOHPHQW RI ); WUDQVDFWLRQV QRUPDOO\ SURFHVVLQJ Proposals (RFPs), which were won by the aforementioned approximately $7 trillion equivalent, with approximately vendors. Each repository will take data submissions from one million instructions per day. all users of OTC contracts and hold copies of the data on behalf of the submitters. Each repository can then provide reports and summary data to regulators in appropriate circumstances.

CROSSINGS: The Journal of Trading & Risk Management 14 Other Services to engage with these individual groups, plus additional staff for participation in the resulting implementation 2XWVLGH FOHDULQJ ¿UPV PDNH H[WHQVLYH XVH RI WKH ,6'$ projects. The effect of the rapid change in the OTC Credit Support Annex (CSA) to mitigate credit exposure, infrastructure space has made it virtually impossible for which itself relies upon quality data on the composition VPDOOHU¿UPVWRSDUWLFLSDWHRWKHUWKDQVHOHFWLYHO\ and valuation of trades in each bilateral portfolio. There are many providers of Portfolio Reconciliation services, )RUPRUHPRGHVWO\VL]HGEDQNVDQGEX\VLGH¿UPVWKHRQO\ which attempt to clean up breaks in respective trade pragmatic approach is to carefully prioritize investments. portfolios to avoid disputes on margin calls. In order to understand the level of investment required, it is necessary to keep up with the activity in the capture 0DQ\ EX\VLGH ¿UPV XVH 7KLUG3DUW\ $GPLQLVWUDWRUV DQG FRQ¿UPDWLRQ VSDFH 7KH ¿UPV WKDW FRPSULVH WKH 73$V WRKDQGOHWKHLUPLGGOHDQGEDFNRI¿FHIXQFWLRQV OSC must commit fully to the targets in the letters sent which in turn use third parties to provide independent WRWKH)5%1<2WKHU¿UPVZLOOQRWEHGLUHFWO\DIIHFWHG valuations for trades, including OTC portfolios. but the pace of change resulting from these commitments will indirectly affect everyone in this space, bringing new processing models and requirements, including: Impact on Participants *LYHQ WKH FXUUHQW ODQGVFDSH LW LV FOHDU WKDW IXOO 27& New trade execution platforms participation requires a substantial investment in ExpandeG FRQ¿UPDWLRQ SODWIRUPV LQFOXGLQJ SRVW technology and people. ISDA runs numerous meetings to trade events, such as novation consent drive the industry-wide change program, facilitating more than 54 steering committees, implementation groups, and Expanded clearing platforms and product scope other working groups that cover various asset classes. To Reconciliation and settlement services SDUWLFLSDWHD¿UPPXVWFRPPLWEHWZHHQWHQWRWZHQW\VWDII

ISDA Industry Governance Committees

Equities Rates Commodities Credit

10 8 7 9

Collateral Asia Operations

8 7 5

= Number of active working groups and/or steering committees

Figure 3: ISDA Steering Committees and Working Groups

15 Processing Check List Measure the cost-per-trade for OTC portfolios and benchmark this information with industry peers $Q\¿UPWUDGLQJ27&SURGXFWVPXVWGHYHORSDIRUZDUG looking plan to measure and manage the cost of processing Understand and plan for the impact of new U.S. and them. This check list of tasks should include: EU regulation

Analyze automation opportunities for front-to-back Coordinate and prioritize investment in the post-trade electronic processing environment

Understand the commitments to the FRBNY by the ISDA OSC Committee and associated deadlines Prepare for the Future Review offerings from CCPs for products supported As discussed in the previous article by Chris Ekonomidis and evaluate the business case for using them and Ryan Baccus, the new U.S. reforms and the indications of new regulations in Europe will drive greater ISDA OPERATIONS STEERING COMMITTEE transparency and automation during trade processing. The dealers trading OTC derivatives have made great strides DEALER FIRMS in becoming more automated in OTC trade processing. Bank of America – Merrill Lynch This automation has and will continue to lower processing Barclays Capital costs, as well as reduce . It is the issue of BNP Paribas transparency where the key stakeholders in the industry Citigroup will reluctantly comply with new reforms. For example, Credit Suisse the movement of all OTC derivatives to an exchange Deutsche Bank A.G. will reduce bank margins, the use of CCP will result in Goldman Sachs & Co. more control by the regulators, and, indeed, some of the HSBC Group reforms, such as trades having to be transacted through an JPMorgan Chase electronic platform that is independent of any investment Morgan Stanley bank, may close the door to lucrative investment bank The Royal Bank of Scotland Group equity investments. With all of these pending changes, Société Générale it is important for OTC market participants to keep fully UBS A.G. informed of new offerings and developments in order to Wachovia Bank, N.A. optimize opportunities in advance of, or at least in pace with, their peers. BUY-SIDE FIRMS

AllianceBernstein BlackRock, Inc. Bill Hodgson is a Director based in London and BlueMountain Capital Management L.L.C. leads the central clearing practice Citadel Investment Group L.L.C. for Sapient. Prior to joining Sapient, D.E. Shaw & Co., L.P. Bill worked on building the Trade D.W. , L.P. Information Warehouse (TIW) at Goldman Sachs Asset Management, L.P. DTCC and was head of Product Pacific Investment Management Company, L.L.C. Development for LCH Clearnet’s SwapClear. Wellington Management Company, L.L.P. [email protected] INDUSTRY ASSOCIATIONS

International Swaps and Derivatives Association (ISDA) Ryan Baccus Managed Funds Association (MFA) is a Director based in London with Asset Management Group (AMF) of the Securities extensive derivatives experience. Industry and Financial Markets Association (SIFMA) Ryan currently serves as the Program Manager for the DTCC Figure 4: ISDA Operations Steering Committee Project Management Office (PMO) to regulate the OTC Derivatives standardization and automation of Straight Through Processing (STP). [email protected]

CROSSINGS: The Journal of Trading & Risk Management 16 LOAN TRADING: market reform

On both sides of the Atlantic, the supervisory community is pushing for standardized documentation, processes, central clearing, and, where possible, exchange-based trading of Over-the-Counter (OTC) derivatives. Current U.S. regulation discussions also consider the requirement of swaps desks to be spun off from banks in order to isolate the risk from depositors. Whether intentional or not, the new regulations will affect the loan market, and industry participants are concerned that liquidity could be reduced as a result. Bernadette Conway and Karl Page discuss the implications of potential reforms on the loan markets in Europe and the United States.

Historically, the loan market has been a private one, Volcker Rule especially within the European trading community. The U.S. Senate bill contemplates the Volcker Rule, which Trades are not reported through exchanges and trade would ban Federal Deposit Insurance Corporation (FDIC) prices are not disseminated through the Trade and banks from any risky trading that is not related to customer Compliance Engine (TRACE) developed by Financial trading. The Volcker Rule would eliminate any proprietary Industry Regulatory Authority (FINRA) to facilitate trading within the investment banks. Although the Volcker the mandatory reporting of OTC secondary market Rule would have a major impact on all of the trading desks WUDQVDFWLRQVLQHOLJLEOH¿[HGLQFRPHVHFXULWLHV,ISRUWIROLR within the investment bank, the distressed loan trading managers and/or traders are using Loan Credit Default desks could be hit the hardest. Most investment banks Swap (LCDS) positions to hedge loan risk, it can be trade distressed bank debt through their banking entity. assumed that the reporting of LCDS trades will be a de Hence, if proprietary distressed loan trading is no longer facto reporting of loan positions. There is talk that some allowed within the bank entities, where will the investment hedges could receive exemptions from clearing and banks house their proprietary distressed loan positions? exchange requirements, but those exemptions are likely to have differences in U.S. and EU regulations. Although One solution might be that banks are forced to move mandatory clearing and standardization will deeply affect these trading operations into their securities entities. many loan market participants, other areas of reform This approach will result in the loan positions receiving will have more widespread effects on loan trading. The a more punitive capital treatment than their securities loan market faces additional regulatory burdens with FRXQWHUSDUWV &KLHI )LQDQFLDO 2I¿FHUV DQG VHQLRU the inception of potential risk retention requirements management will also be hesitant to man loan trading and complying with the Volcker Rule requirements, as positions in their securities entity because loans cannot be well as hedge fund and private equity fund registration rehypothecated. The additional cost of capital that would requirements. EHUHTXLUHGWRUXQDEXVLQHVVIURPDVHFXULWLHV¿UPFRXOG force several market participants out of the business. As Both the U.S. House of Representatives (House) and Senate the Volcker Rule, or an equivalent concept, is not part of bills, as well as previous discussions by the European the European Central Bank’s current regulation reform Central Bank, focus on the requirement of lenders to agenda, U.S. investment banks may also look at their retain a portion of the loans they extend. European European entities as potential locations to house their ¿QDQFH PLQLVWHUV KDYH VLQFH LQGLFDWHG WKDW 9ROFNHUOLNH distressed loan operations. Relocation to a European rule restrictions would violate EU universal banking laws. entity will increase set up expenses and complicate cross- ,IWKH86LVWKHRQO\PDMRU¿QDQFLDOPDUNHWWRHQIRUFH border taxes. restrictions on proprietary trading within banks, it would disarm the banks against their international competitors.

17 Non-Bank Issues as they are still the lender of record and retain all funding requirements to the borrower. Sellers may require The new requirement for hedge funds to report multiple WKH KHGJH IXQG WR SRVW FROODWHUDO WKDW ZLOO VLJQL¿FDQWO\ data points to the supervisory community is a focus for increase the cost of trading distressed loans because of the both EU and U.S. lawmakers. The EU is also looking to additional exposure to the hedge fund. require private equity and third-world country funds and asset managers to adhere to strict requirements if Under the potential new reforms, sellers of loans will also they have the intention of soliciting business from EU- be required to create an infrastructure to support the based investors. The culture of hedge funds and their collateral process. Hedge funds will have to post collateral private equity counterparts is one of secrecy and private in the form of cash or cash-equivalent securities to offset agreements. Hedge funds will often accumulate large the risk that the seller has to fund future obligations to the loan positions of troubled companies in anticipation of a borrower. Increases in cost will certainly have an effect on EDQNUXSWF\RULQVROYHQF\¿OLQJ7KHKHGJHIXQGVZLOOWKHQ trading volumes, as broker dealers will be less inclined to look to play a controlling role in the creditors’ committee, do trades where they are only making a small spread. while restructuring or liquidating the borrower’s assets. Currently, these positions are acquired quietly and without public knowledge. Often, participations will be used as a form of transfer as to protect the identity of the Loan-Specific Issues – Europe risk holder. If the supervisory community is required to Supervisors globally have begun to focus on the risks report bank debt positions by the hedge funds, the ability in secondary loan trading that arose during the recent to transfer assignments of stressed bank loans could be ZRUOGZLGH¿QDQFLDOFULVLV(8PDUNHWSDUWLFLSDQWVVXIIHUHG limited. credit losses due to the collapse of Lehman Brothers and its subsidiaries when they incurred unsecured losses with Also, under standard loan closing processes, borrower trading counterparties during the settlement period. approval is required for every new lender looking to come into a deal. The borrower is not allowed to unreasonably As discussed earlier, it is quite common for secondary loan withhold such approval. Under current market practice, a trades to settle as participations or sub-participations in borrower would not necessarily know if a new lender was the European market. Participations vary greatly between also a lender to the borrower’s competition. Lenders in the U.S. and the EU market. In the U.S. loan market, a bank debt have access to Material Non-Public Information SDUWLFLSDQWLVJUDQWHGDEHQH¿FLDORZQHUVKLSLQWHUHVWLQ (MNPI). the underlying loan.

Some lenders may choose not to access MNPI, but That is not the case in the European loan market, as under that does not alter the fact that the lender could access the Loan Market Association (LMA) sub-participation it if it wanted. Borrowers would not necessarily want agreement, a loan is granted from the sub-participant to lenders of their competitors, especially those that hold the grantor in the amount of the purchase price and only large positions in their competitor’s bank debt, to also repaid to the extent that the borrower makes payments on have MNPI about their own company. Understandably, the underlying loan. Under such an agreement, a debtor/ borrowers would be concerned that private information creditor relationship is created between the grantor and about investments, R&D, merger and acquisition activity, the sub-participant. The sub-participant has a contractual etc., could potentially wind up in the hands of their agreement only with grantor, and so the sub-participant competition or those in control of their competitor’s does not: credit committee. Because of this concern, borrowers may Become a direct party to the underlying loan reject assignments to such hedge funds. As an alternative, hedge funds may look at transferring loan positions via Receive rights or obligations under the credit assignment. The ability to transfer via an assignment in documentation the U.S. market is less complicated than the EU market Receive proprietary interest in the loan or the credit and is, therefore, a viable solution. Selling participations documentation to a hedge fund increases the risk for the sellers though,

CROSSINGS: The Journal of Trading & Risk Management 18 Under an LMA sub-participation agreement, if the grantor to the (CDS) market in 2005, the ¿OHV IRU LQVROYHQF\ WKH VXESDUWLFLSDQW PHUHO\ KDV WKH supervisory community is concerned about the backlog right to claim, as an unsecured creditor, the unpaid RI RSHQ FRQ¿UPV DQG WUDGHV WKH EURNHU GHDOHUV KDYH amounts due under the sub-participant agreement. This is amassed. The secondary loan market does not have standard insolvency process, given the contractual rights the complications of “trade assignments” like the CDS of the sub-participation agreement, and is not a unique market had, but there are many similarities to today’s circumstance to the Lehman insolvency. The Lehman current loan market and the CDS market of 2005. In a administrators are still paid by borrowers for loans that 2007 report on Credit Derivatives, the United States Lehman held but sub-participated out, however, the sub- *RYHUQPHQW $FFRXQWDELOLW\ 2I¿FH *2$  RXWOLQHG participant has no claims to those payments except as an one of the main contributing causes of the backlog of unsecured creditor. RSHQ FRQ¿UPV DQG WUDGHV WR ³GHDOHUV DQG HQGXVHUV UHO\LQJ RQ LQHI¿FLHQW PDQXDO SURFHVVHV WKDW FRXOG QRW Many sub-participants did not understand the contract adequately keep up with the rapidly growing volumes.” they had made or the risk they were taking. In the EU, the That statement can accurately be made today by the supervisory community is keenly aware of the potential supervisory community about the state of the secondary losses sub-participant banks may take as the Lehman loan market as well. According to the Loan Syndications estate is settled. They are also aware of the fact that banks and Trading Association’s (LSTA) First Quarter 2010 were not reporting such risk or exposure. This lack of Trading Study, there was $44.8B in total open trades at transparency in risk reporting has raised questions by WKHHQGRIWKH¿UVWTXDUWHURI7KLVLVVXHLVODUJHO\ the supervisory community as to what other loan trading due to the manual processes and settlement times that risks they are not aware. The loan trading market may not remain extended well beyond recommended settlement be the current priority for the EU supervisory community, timeframes. According to the same study, par settlement but the supervisors will clearly look to address this times are T+18 (versus LSTA-recommend settlement issue soon. of T+7) and distressed settlement timeframes continue to expand with an average of T+68 for Q1 2010 (versus /67$UHFRPPHQGHG VHWWOHPHQW RI 7  *LYHQ WKH Loan-Specific Issues – U.S. VLPLODULWLHVLQRSHUDWLRQDOLQHI¿FLHQFLHVDQGRXWVWDQGLQJ The U.S. loan market has also raised the supervisory risk in today’s current loan trading market compared community’s interest. The trigger for regulatory interest to the CDS market in 2005, it can be surmised that the in the U.S. loan market is related to trade volumes that supervisory community could take similar actions within FUHDWHGDQXQSUHFHGHQWHGEDFNORJRIRSHQWUDGHFRQ¿UPV the loan market as they did within the CDS market. open trades, and extensive settlement periods. Similar

Sub-participant becomes unsecured creditor of the grantor’s estate

Credit Agreement/ Grantor Sub-Participant Borrower

Only the grantor is a direct party to the credit agreement rights Grantor has a contractual obligation to and obligations under the credit pass along all payments and fees to the agreement remain with the grantor sub-participant but, in the case of the grantor facing an insolvency, the payments made by the borrower to the grantor become part of the estate of the grantor

Figure 1: Risks and Relationships in an LMA Participation

19 Loan market participants are familiar with the actions Clearly, there are issues in both the U.S. and EU loan trading taken by U.S. and foreign supervisory communities markets that must be addressed. Market participants on organized by the Federal Reserve Bank of New York both the buy side and the sell side should take advantage (FRBNY) in September 2005. The supervisory community of current market initiatives, and take stock of their own prompted 14 major credit derivatives dealers to work processes and infrastructures. It is key for loan market WRJHWKHUWRUHGXFHWKHQXPEHURIXQFRQ¿UPHGWUDGHVDQG participants to learn lessons from the OTC participants— address the underlying causes of these backlogs. In the namely, to take it upon themselves to address the issues earlier article by Bill Hodgson and Ryan Baccus in this E\ LQVWLWXWLQJ ZRUNÀRZV LQFOXGLQJ ZRUNVKRSV EHWZHHQ edition of Crossings, we can see how far the OTC market major participants, setting out a roadmap, and using such has come in automating the infrastructure to successfully measurable milestones as metrics reporting to ensure GHDOZLWKWKHRXWVWDQGLQJFRQ¿UPDWLRQLVVXH all participants are adopting the changes. It is far better that the industry works together to improve its own infrastructure, rather than wait for regulators to impose a Changes in Advance of New Regulation more rigid set of rules that could adversely affect liquidity Already, the loan market has started to address these DQGKHQFHSUR¿WDELOLW\ issues by ensuring that there are electronic documentation SODWIRUPVWRH[HFXWHFRQ¿UPVDQGWUDGHGRFXPHQWDWLRQ in the par trading market. Some broker dealers claim Bernadette Conway 98% coverage of trading volumes. The distressed trading is a Director based in New York. market is catching up to the par market with vendors She had operational oversight for recently completing distressed functionality. Market all loan and distressed trading at initiatives include issuing Committee on Uniform JP Morgan and was Director of Operations at Cerberus Capital 6HFXULWLHV,GHQWL¿FDWLRQ3URFHGXUHV &86,3V DQG0DUNLW before joining Sapient. (QWLW\ ,GHQWL¿HUV 0(,V  DQG XVLQJ )LQDQFLDO SURGXFWV [email protected] Markup Language (FpML) to transfer messages between agents, lenders, and trading counterparties. There are also initiatives underway to create Straight Through Processing (STP), including Delivery Versus Payment (DVP) settlement. Loan market participants are certainly Karl Page ahead of their CDS counterparts from 2005, but more is a Director based in London focus is needed if the market is to avoid severe reprimands with more than 22 years of loan from regulators. experience in the front, middle, and back offices of major banks. Previously, Karl held various positions at ABN AMRO, including head of European loan agency. [email protected]

CROSSINGS: The Journal of Trading & Risk Management 20 INSURANCE: risk, regulation, and the path to Solvency II

The insurance sector in Europe is facing an exciting period of change. Occasionally overlooked in relation to the banking sector, the insurance market forms an important part of the financial services industry. However, like the banking reforms currently being discussed, the insurance industry faces new legislation in the form of Solvency II. Winn Faria and Paul Saunders outline the risks broadly associated with the insurance and banking sectors and discuss the potential impact on global insurers with European subsidiaries of Solvency II.

There are two sectors in the insurance market: Long-Term Key Risks for Life Insurers Insurance (Life) and general insurance (non-Life). Long- Market conditions continue to put pressure on insurers’ term insurance, typically covers life insurance, pensions, earnings and excess capital. Those life insurers more annuities, and critical-illness insurance. Life insurers exposed to falls in asset values run a greater risk of excess provide cover for claims against the insured life in the form capital reductions and, potentially, capital requirement of a policy designed to offer compensation in the event of breaches. unexpected death. Long-term insurance now accounts for the majority of the U.K. insurance market by value. Although the United Kingdom life sector has, on the The second, general insurance, comprises car insurance, whole, withstood the recent stressed market conditions, property insurance, accident, health, and general liability LWPD\¿QGLWGLI¿FXOWWRWDNHIXUWKHUPDQDJHPHQWDFWLRQV LQVXUDQFH*HQHUDOLQVXUHUVFRYHUHYHU\RWKHUSROLF\RWKHU to preserve capital in the event of another economic than life. Both sectors, akin to the banking industry, are decline. currently regulated by the Financial Services Authority (FSA) in the U.K. 6RPH SURSULHWDU\ OLIH LQVXUHUV PD\ DOVR ¿QG LW GLI¿FXOW to raise additional capital from investors. As a result of In a recession, insurance claims tend to increase in this and other factors, the life sector continues to explore number, size, and diversity. There are a number of well- innovative ways of leveraging capital. documented reasons for this, such as increased levels of “social” crime, like theft, which affects property and There is an expectation that insurers will review such YHKLFOHVDQGLQFUHDVHG¿QDQFLDOORVVHVIURPFUHGLWFDUG ideas critically, to ensure that there is genuine risk transfer and mortgage defaults. Additionally, there can be higher DQGWRDYRLGVROXWLRQVWKDWPD\DUWL¿FLDOO\PDQXIDFWXUH levels of claims fraud and a greater propensity to claim. capital. There can also be changes in types of claim, for example, more liability claims. There are other potential capital and solvency concerns. Inadequate monitoring of solvency positions may lead The world’s population as a whole is also living longer. WR LQVXUHUV EHLQJ XQDEOH WR WDNH VXI¿FLHQW DFWLRQ HDUO\ This can be attributed to a better lifestyle, healthier living, HQRXJKWRUHGXFHWKHULVNRI¿QDQFLDOIDLOXUH,WPD\DOVR and advanced disease control, among other things. By increase the risk that actions taken to conserve capital will 2040, the world’s population aged 60 and over will more result in poor consumer outcomes. than triple to two billion people. In the next 30 years, for WKH¿UVWWLPHLQKXPDQKLVWRU\WKHUHZLOOEHPRUHSHRSOH Secondly, insurers could fail to value illiquid assets in a on the planet who are over 60 than those under the age of prudent manner, leading to an overstatement of asset 15. This has serious long-term implications on such areas YDOXHVDQGSRWHQWLDOVROYHQF\GLI¿FXOWLHV as life insurance, pension provision, and healthcare.

21 Key Risks for General Insurers Banks and Insurers Shared Risks – Reserving adequacy has re-emerged as an issue for general Market and Economic LQVXUHUV5HVHUYHVDUHD¿QDQFLDOLQVWLWXWLRQ¶VDVVHWVNHSW Both banks and insurance companies are affected by market in cash in a liquid form as a reasonable provision for and economic risk. In particular, banks face market risk in PHHWLQJ DOO IXWXUH GHPDQGV 5HFHQWO\ ¿UPV KDYH EHHQ WZR PDLQ DUHDV 7KH ¿UVW LV LQ UHODWLRQ WR WKH PDUNHWDEOH releasing surplus reserves in order to improve earnings; securities held by the bank. The second has to do with however, there is concern that newer levels of release are assessing this risk in conjunction with the market risk related likely to be unsustainable. to positions in the complex instruments to which many banks are counterparties. 6RPH ¿UPV ULVN FRPSRXQGLQJ WKHVH SUREOHPV E\ underpricing new business to remain competitive. Lower Market risk for general insurance companies relates to investment returns and a more limited scope to release the portfolio of marketable assets held and is also closely prior-year reserves mean that general insurers need to UHODWHG WR WKH DVVXPSWLRQV XVHG IRU FODLPV LQÀDWLRQ )RU FRQWLQXHWRXQGHUZULWHRQSUR¿WDEOHWHUPVDVWKH\FDQQRW life insurance companies and pension schemes, the market rely on investment income or reserve releases to subsidise risk in asset portfolios is linked to the various economic underwriting losses. assumptions used to value the liabilities, in particular the rate at which these liabilities are discounted. /DWHQW FODLPV UHODWLQJ WR WKH ¿QDQFLDO FULVLV UHPDLQ D concern, although there is considerable uncertainty over when and how these might materialize. In the meantime, Shared Risks – Credit Risk ¿UPV ZKR PD\ KDYH H[SRVXUH WR VXFK FODLPV QHHG WR Credit risk results from the chance that the opposite side carefully consider their approach to reserving and capital of a trade will be unable to make a payment. For general planning. and life insurance companies, the main credit risk faced is that the reinsurer fails. This risk is linked to longevity The recession may have fundamentally changed the RUPRUWDOLW\ULVNIRU¿UPVZULWLQJOLIHLQVXUDQFHEXVLQHVV nature of certain insurance risks underwritten within both and to non-life insurance risk for those writing non-life personal and commercial lines; the latter, for instance, business. UHÀHFWLQJ FKDQJHV WR WKH VWUXFWXUH DQG RSHUDWLRQ RI WKH manufacturing industry and commerce across the broader The greatest risk for most pension schemes is that of economy. This has implications for underwriting, pricing, sponsor insolvency. and reserving.

The slowdown of economic activity in 2008/09 affected Shared Risks – Operational Risk business volumes across several lines of general insurance. Firms will be looking to bolster margins by taking actions If not managed correctly, these risks can be the biggest that could cause consumer detriment; for example, faced by any organization. Operational failures have led to applying unfair contract terms (such as what occurred in WKHGHPLVHRIPRUHWKDQRQH¿UPEHFDXVHSRRUFRQWURORI 2009 with Mortgage Payment Protection Insurance (PPI)), operational risk allows other types of risk to manifest. Market unfairly rejecting claims, reducing claims payments, or or credit risk can become excessive. On a less extreme level, introducing products that do not appear to offer any real operational failures or inadequacies can result in mistakes FRQVXPHUEHQH¿WV DQG LQHI¿FLHQFLHV WKDW OHDG WR ¿QHV RU ORVW EXVLQHVV 3RRU project management and strategic management and Further sizeable movements in exchange rates also pose decision making also need to be considered. WKUHDWVWRSUR¿WDELOLW\DQGFDSLWDO,QVRPH¿UPVFDSLWDO may be held in a different currency to address certain insurance liabilities. Moreover, even where all business is carried out in one jurisdiction, the cost of claims may be related to the cost of materials manufactured elsewhere, extending even to those without international operations.

CROSSINGS: The Journal of Trading & Risk Management 22 Regulation In practice, Basel II attempted to accomplish this by setting Basel II, initially published in June 2004, was designed to up rigorous risk and capital management requirements, create an international standard that banking regulators all of which were designed to ensure that a bank would could use when creating mandates about how much hold capital reserves appropriate to the risk the bank capital banks needed to put aside to guard against several exposed itself to through its lending and investment W\SHVRI¿QDQFLDODQGRSHUDWLRQDOULVN$GYRFDWHVRI%DVHO SUDFWLFHV*HQHUDOO\VSHDNLQJWKHVHUXOHVPHDQWWKDWWKH II believed that such an international standard could help greater risk to which the bank was exposed, the larger the SURWHFWWKHLQWHUQDWLRQDO¿QDQFLDOV\VWHPIURPWKHW\SHV amount of capital it needed to hold in order to safeguard of problems that might arise should a major bank or a its solvency and overall economic capital. series of banks collapse.

10 Public disclosure of risk exposure and quality of management DISCLOSURE

Regular evaluation of strategies, 9 policies, procedures, and practices ROLE OF SUPERVISORS

Ensure banks have effective 8 framework in place

airly 7 Contingency and business continuity plans F

ROCESS RISK MANAGEMENT: IDENTIFICATION,

P Policies, processes, and procedures to mitigate risks MEASUREMENT, MONITORING, AND CONTROL 6 ustomers ustomers C 5 Monitor risk profiles and losses – KRIs nc. Operational Risk nc. Operational I RROW redit Risk Boundary redit oncentration Risk, etc. oncentration C AAP reating reating C Identify and assess risks in products, activities, processes, T 4 IC

FSA A FSA systems by CRSA, mapping, and KRIs, etc. DEVELOPING AN APPROPRIATE RISK MANAGEMENT ENVIRONMENT 3 Senior management responsible for implementing the framework

2 Framework subject to effective and comprehensive internal audit 1 Board sets – strategy and framework plus oversight

In a Solvency II environment, ARROW replaces ICAAP with ICAS

Figure 1: The 10 Principles of Sound Operational Risk Management Under Basel, Pillar II

23 The Solvency II Directive As recently as last year, the Basel Committee published its At a high level, Solvency II can be considered the insurance proposals for the banking sector in relation to capital and industry equivalent of Basel II for the banking industry. OLTXLGLW\DQGLQUHVSRQVHWRWKHZDNHRIWKH¿QDQFLDO The aim of this directive is to develop a new solvency crisis. Dubbed Basel III, it has a similar implementation system that can be applied to life assurance, non-life timeline to Solvency II in 2013, with grandfathering LQVXUDQFH DQG UHLQVXUDQFH ¿UPV ZKLFK PHPEHU VWDWHV arrangements thereafter, and aims to strengthen global and supervised institutions are able to apply in a robust, capital and liquidity regulations with the goal of promoting consistent and harmonized way. a more resilient banking sector.

A three-pillar approach, similar to Basel II is envisioned:

PillDU,4XDQWL¿FDWLRQRIFDSLWDOUHTXLUHPHQWV

Pillar II: Supervisory review process

Pillar III: Market analysis of published data

PILLAR I APPROACHES: “The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.” Includes , but excludes strategic BASIC INDICATOR APPROACH: and reputational risk. ‡$OOEXVLQHVVW\SHV¥*URVV,QFRPH[

THE STANDARDIZED APPROACH: ‡&RUSRUDWH)LQDQFH¥*URVV,QFRPH[ ‡7UDGLQJ 6DOHV¥*URVV,QFRPH[ ‡5HWDLO%DQNLQJ¥*URVV,QFRPH[ BASIC INDICATOR ‡&RPPHUFLDO%DQNLQJ¥*URVV,QFRPH[ APPROACH ‡3D\PHQW 6HWWOHPHQW¥*URVV,QFRPH[ ‡$JHQF\6HUYLFHV¥*URVV,QFRPH[ ‡5HWDLO%URNHUDJH¥*URVV,QFRPH[ ‡$VVHW0DQDJHPHQW¥*URVV,QFRPH[

THE STANDARDIZED THE ALTERNATIVE STANDARDIZED APPROACH: APPROACH ‡5HWDLO%DQNLQJ¥/RDQV $GYDQFHV[[ ‡&RPPHUFLDO%DQNLQJ¥/RDQV $GYDQFHV[ [ ‡$OORWKHUEXVLQHVV¥DVSHUWKH6WDQGDUGL]HG Approach THE ALTERNATE STANDARDIZED APPROACH ADVANCED MEASUREMENT APPROACH: ‡%DVHGRQRXWSXWIURPLQWHUQDORSHUDWLRQDOULVN measurement/modeling approach Minimum regulatory capital requirement capital Minimum regulatory ‡6XEMHFWWRFRPELQHGUHJXODWRU\FDSLWDO©IORRUª IRURSHUDWLRQDOFUHGLW PDUNHWULVNV¥RI ADVANCED current minimum capital requirements for 1st MEASUREMENT APPROACH \HDU IRUQG\HDU

3-year average of gross income is employed in the capital estimate Sophistication of operational risk practices

Figure 2: Operational Risk under Basel, Pillar I

CROSSINGS: The Journal of Trading & Risk Management 24 Risk Sensitive Banking System Risk Sensitive Insurance System

apital apital C apital apital C Market Review Discipline Reporting Min. Governance Supervisory Requirement Requirement Requirements Solvency Solvency

FSA Handbook FSA Handbook Committee of European Insurance and Occupational The Committee of European Banking Supervisors (CEBS) Pensions Supervisors (CEIOPS)

Basel II & Capital Requirements Directive Solvency II

BASEL II SOLVENCY II

MINIMUM CAPITAL REQUIREMENT SOLVENCY CAPITAL REQUIREMENT For Credit, Market, and Operational Risk different levels of Requires that minimum solvency capital requirements be sophistication are possible. As the degree of sophistication set and that a firm should be familiar with the structure becomes apparent, the capital requirement declines which is a and application of the Solvency Capital Requirement (SCR) major incentive to move to the more sophisticated approaches. as articulated in QIS 4, the fourth of a series of Quantitative Impact Studies (QIS) published by CEIOPS. Alternatively, firms SUPERVISORY REVIEW may calculate their SCR using an internal model. This may Senior management sponsorship, risk strategy and policy represent a more efficient use of capital – but it will be subject setting, organizational structure, risk categorization, qualitative to initial and ongoing supervisory approval. and/or quantitative risk assessment methodologies and tools, management and risk reporting, training, and education GOVERNANCE programs. Ensuring compliance with the Sound Practice Requires regulated firms to assess and manage the risks to document. Links to existing initiatives. which they are exposed and to assess their own capital needs and maintain that capital. The firm’s assessment of its capital MARKET DISCIPLINE needs and of its risks is subject to supervisory review. Qualitative disclosures of the operational risk approach adopted and quantitative disclosures for the more advanced REPORTING REQUIREMENTS approaches. Requires regulated firms to publicly disclose key information that is relevant to market participants. Its purpose is to enhance market discipline on the regulated firm.

Figure 3: Basel II vs Solvency II

Therefore, Solvency II becomes a fundamental review 7KHQHZUHJLPHLVH[SHFWHGWRDSSO\WRDOOLQVXUDQFH¿UPV of the capital adequacy regime for European insurers with gross premium income exceeding EUR 5 million, or and reinsurers and is planned to take effect in January gross technical provision in excess of EUR 25 million. In 2013. Its aim will be to establish a revised set of EU-wide addition, it will help provide a pan-European, Enterprise capital requirements, valuation techniques, and risk- Risk Management (ERM) based solution. management standards to replace the current Solvency I requirements.1

1 Solvency I is the name given to changes to the EU’s insurer solvency regime of 2002. The EU’s insurer solvency regime was put in place in the 1970s. Solvency I did not fundamentally change the requirements and, in the process of making the changes, it became clear that a more wide-ranging reform was required—hence Solvency II.

25 Maximizing Opportunities within Process reengineering and an increased focus on Solvency II/Basel III compliance and corporate governance means that some Insurance and banking sector companies need to be aware ¿UPV ZLOO QHHG WR VLJQL¿FDQWO\ XSJUDGH WKHLU SURFHVVHV of the impact that both Solvency II and Basel III will have and resources. Clients should be looking to use this as an on their capital position, and of the demands it will place RSSRUWXQLW\WRVWUHDPOLQHZRUNÀRZDQGRSWLPL]HUHVRXUFH on their people, pre-, during, and post-implementation. allocation. Effective implementation of these new regimes will bring FRQVLGHUDEOHORQJWHUPEHQH¿WVWRWKH¿QDQFLDOVHUYLFHV Additionally, technology systems may need to be upgraded VHFWRU DQG VKRXOG LPSURYH WKH TXDOLW\ RI D ¿UP¶V ULVN to deliver new requirements within pre-designated management potential. timeframes. This may include advanced techniques in risk and modeling, data scrubbing, data collection, analysis, Solvency II and Basel III will require closer cooperation reporting changes and balance sheet substantiation and EHWZHHQ WKH SULFLQJ ULVN DQG ¿QDQFH IXQFWLRQV WKDW rationalization. currently operate as separate entities. Clients should EH ORRNLQJ WR HPEUDFH FKDQJH DQG KDUPRQL]H EHQH¿W Firms that are in a position to offer these institutions realization through this new regulatory environment. complementary implementation services that include strong project and change management skills and Changes to a bank’s or insurer’s capital requirements will modeling, coupled with advanced risk expertise, will present both opportunities and threats to their strategies. JUHDWO\EHQH¿W &OLHQWV VKRXOG EH ORRNLQJ WR XQGHUWDNH VLJQL¿FDQW LQQRYDWLRQLQRUGHUWRHQVXUHSURGXFWVUHPDLQSUR¿WDEOH within these new frameworks.

CEIOPS provides final Level 2 implementation EFFORT LEVEL advice on implementation approved H2 2010 Oct 2009

Solvency II in force, Draft framework directive CEIOPS Report Framework directive CEIOPS finalizes Level 3 Jan 2013 published July 2007 May 2008 approved Apr/May 2009 guidance H2 2010

QIS 3 Report QIS 4 Report Nov 2007 Nov 2008

MILESTONES

QIS 4 2007 2008 Apr–Jul 2009 2010 QIS 5 2011 2012 2013 2008 FSA TIMELINES CURRENT POSITION FSA notified of Solvency II project lead Mar 2009

Firms to notify of Dry runs of models Formal submission to Model approval intention to seek internal for approval FSA for approval effective model approval

Figure 4: Insurance Sector Actions Mapped to Solvency II Milestones

CROSSINGS: The Journal of Trading & Risk Management 26 GATEKEEPER GATEKEEPER SCOPE GAP ANALYSIS PROGRAM IMPLEMENTATION BUSINESS REVIEW REVIEW WEEK 0 WEEKS 1-4 WEEK 4 ONWARD AS USUAL WEEK 4 QUARTERLY

Understand Internal Model Company’s Risk Management and Governance Regulatory Strategic Objectives Approval

Implementation Define Project Review Company’s Modeling Internal Approval Monitor Scope Initial Gap Analysis Plan & Actions

QIS Exercises Systems and Data Continuous Company’s Findings Review

Planning and Documentation Ongoing Model Business Case Validation

Detailed Management Information Transition to Gap Analysis Business as Usual

Integrating Solvency Revisit Disclosure II requirements Business Case within the business and identifying Gap identification and critical path with Implementing the Solvency II program, improvements before consideration of insurers structural, understanding the interdependencies, and formally seeking business, and operational strategic plan keeping the Board informed of progress regulatory approval

Figure 5: Solvency II – Route Map, Risk, and Governance

Partnering with risk solution providers must also Winn Faria IRUP D FULWLFDO SDUW RI D ¿UP¶V &XVWRPHU 5HODWLRQVKLS is a Senior Manager based in London. With 15 years’ project Management (CRM) strategy. Either by way of a joint management and delivery venture or other symbiotic relationship, this can create experience gained at a variety a more wholesome service offering, especially in the key of financial services institutions, areas of risk, compliance, and audit. Winn is PRINCE2-qualified, an associate of the Institute The changing regulatory environment offers the of Actuaries, and a qualified Manager. opportunity to use an increased budget pool to tackle work [email protected] streams within programs that otherwise would not have been attempted and to improve strategic assessments. &OLHQW¿UPVVKRXOGKRZHYHUDFWQRZWRDYRLGWKHEDFN Paul Saunders is a Director based in London. An loaded costs commonly associated with these regulatory experienced, risk professional, changes. As cautionary note, implementation and delivery Paul is a member of the FRVWVLQFUHDVHGVLJQL¿FDQWO\LQWKHUXQXSWR%DVHO,, Institute of Risk Management and chairs its Operational Risk Special Interest Group. Paul has developed enterprise and operational risk management frameworks, as well as internal change management processes and has managed a global business control, testing, and certification framework to meet Combined Code and SOX reporting requirements. [email protected]

27 REGULATORY SHIFTS AND LESSONS FOR RISK MANAGEMENT: an interview with Dynegy’s Rudi Zipter Q&A Sapient Global Markets recently spoke with client, and seasoned energy markets expert, Rudi Zipter, Vice President of Commercial Trading at Dynegy, about the challenges and issues currently impacting the industry. Rudi shared his take on new regulatory requirements and how organizations can be better prepared to meet them.

(Sapient) 7KDQN \RX YHU\ PXFK IRU DJUHHLQJ WR (Sapient) $QG ZKDW LV \RXU FXUUHQW UROH DW VSHDNZLWKXV5XGL&DQ\RXVWDUWE\WHOOLQJXVKRZ '\QHJ\" \RX¿UVWJRWLQYROYHGZLWKWKHHQHUJ\PDUNHWV" (RZ) I am the vice president in charge of commercial (RZ) Back in 1998, I was working in Chicago when I got trading, and I report in to the executive vice president a call from a Houston-based energy company unknown responsible for all commercial operations within Dynegy. to me at the time. They were looking for someone who , PDLQWDLQ UHVSRQVLELOLW\ IRU ¿QDQFLDO SRZHU WUDGLQJ understood option theory and had experience with risk the company’s hedging strategy, and hourly trading and management system development. I traded soybean dispatch, all with a focus on maximizing the extrinsic value options at the Chicago Board of Trade (CBOT) for a period associated with our 12,500-megawatt power generation of time and had developed a simplistic risk management portfolio. system for the small trading company I worked for so I interviewed with them and eventually landed a job in their risk management department. It was a new angle for (Sapient) In your opinion, what are some of the PHDQGDQLFH¿WVLQFH,ZDVDEOHWROHYHUDJHDYDULHW\RI PRVWH[FLWLQJQHZRSSRUWXQLWLHVLQWRGD\¶VHQHUJ\ different experiences gathered early on in my career. PDUNHWV"

(RZ) Energy markets create a ton of opportunities. I think (Sapient)

CROSSINGS: The Journal of Trading & Risk Management 28 There are huge geopolitical tectonic shifts going on that We could understand positions or sensitivities to our impact our industry. We look at the growth and world asset base demand for energy and the challenge of trying to balance the key objectives of safe operations, reduced emissions, You need all three of those to describe how much risk and generating value for our investors in all commodity you’re taking on and how much opportunity there is. price environments. We must also respond to shifts in These concepts were a little bit foreign to people around regulation. So, there are multiple facets you have to deal the organization, and it took some time to acclimate people with as you build out the energy needs of tomorrow, and to this approach where we modeled the assets, made our as you look at the growth opportunities over time. assumptions, familiarized ourselves with the outputs, and learned how to use them. Now, the terms and processes have become common vernacular around the company. (Sapient) +RZ GR \RX GH¿QH 5LVN 0DQDJHPHQW ZLWKLQ '\QHJ\" :LWK UHJDUGV WR WUDGLQJ DQG When we start talking about risk, we talk about gross ULVN PDQDJHPHQW ZKDW LV \RXU VLQJOH ELJJHVW margin at risk around our assets, with and without the FKDOOHQJH" hedges included. We also talk about our delta position— expected generation—and we understand how that’s (RZ) I think risk management is more than just risk moving, when prices move, or spreads move, or time control. In a lot of organizations, people talk about limits, passes, or volatility changes. We’re able to describe how risk analytics and policies and they try to tell people the value of our portfolio is shifting economically as a what not to do. I think risk management is a lot function of what’s happening in the marketplace. broader than market and credit risk and analytics and policies. It is important to also use risk management The real option model and system has become the to help people make better decisions, to help them foundation for our commercial strategy. understand what to do.

In order to sit at the table with key decision makers (Sapient) :H¶YH ZLWQHVVHG DQ HYROXWLRQ RI WKH of an organization, one needs to have a much broader LQGXVWU\RYHUWKHSDVWVHYHUDO\HDUVZLWKUHJDUGV SHUVSHFWLYHRIZKDW¶VJRLQJRQDQGZKDW¶VLQÀXHQFLQJDQG WRFRPSOLDQFHDQGUHJXODWRU\RYHUVLJKW&DQ\RX shaping the company’s current and future prospects. VXPPDUL]HDIHZRIWKHPRUHUHFHQWUHTXLUHPHQWV LPSDFWLQJ \RXU EXVLQHVV DQG DQ\ VLJQL¿FDQW One of the single biggest challenges I see is that we (risk SURFHVVFKDQJHV\RX¶YHKDGWRPDNHDVDUHVXOW" managers) talk a lot in terms of statistics and theory. ,W FDQ VRPHWLPHV EH GLI¿FXOW WR PDNH WKH GLVWLQFWLRQ (RZ) There’s a ton of changes that we see on horizon with between theory and math to practical applications and regard to how the Federal Energy Regulatory Commission business issues. It is extremely important to deliver the (FERC) and Commodity Futures Trading Commission risk management message to business leaders in a way (CFTC) have implemented various controls after the that allows them to better understand how it can be useful Enron crisis in the early part of last decade, but looking to the organization. IRUZDUGRQHRIWKHWKLQJVZHVHHLVWKHLPSDFWRI¿QDQFLDO regulation reform that’s happening right now. I had been on the risk management side prior to becoming head of commercial trading, so when I started, we began As an Independent Power Producer (IPP), and with our building a real options modeling technique around our current commercial strategy, we look to balance the risks power plant assets and basically, we generated three and the value of our company in the one- to two-year outcomes: timeframe, but we need counterparties, other merchant players, speculators, and banks, to participate in order to We were able to look at the option valuations of our have commodity liquidity in hubs where we operate our asset base business so that we can achieve better, steadier returns. We could look at the risk distribution

29 One thing that has already been voted on in the Senate (Sapient) +RZGR\RXPDQDJHDOOWKHLQIRUPDWLRQ and that they are still looking at very closely is how banks FRPLQJRXWRIWKHYDULRXVUHJXODWRU\DJHQFLHV" will need to conduct business going forward. They are talking about separating merchant [i.e., investment] and (RZ) The experts are regulatory lawyers. All I can say commercial banking again and there’s some chatter about just looking at what other folks are doing is that we’re UHHQDFWLQJWKH*ODVV6WHDJDOO$FWEXWZHGRQ¶WH[SHFWWKLV pushing for standardization. What we’d like to see from SURYLVLRQZLOOEHLQWKH¿QDOELOO the regulatory bodies is a common set of rules so that we can organize our company’s infrastructure to respond to There’s not a lot of clarity as to what direction it’s going, the requests and report in a more timely fashion and as but we know it is likely that something will be decided in accurately as we can. Internally, we’ve built a library of the near future. If banks are asked to clear more of their what we know about the different regulatory agencies, business, the potential result could be less participation in and what they’re looking for. Our goal is to automate all energy trading and less liquidity, and there might be more of these things, so we can respond quickly to the multiple frictional costs—meaning wider bid/ask spreads. agencies that regulate our business.

There are other regulations on the horizon, but they aren’t WRRFOHDU,WKLQNDIWHU¿QDQFLDOUHIRUPWKHQH[WDJHQGD (Sapient) Is that a pipe dream or do you see a item for the White House is Energy and/or Carbon Cap WUHQG WRZDUG FRQVROLGDWLRQ" 2EYLRXVO\ LW ZRXOG & Trade. It’s been talked about for a while now, but was EHDEHQH¿WWRWKHSDUWLFLSDQWVLIWKRVHDJHQFLHV placed on the back burner because of Health Care and FRQVROLGDWHGEXWGR\RXWKLQNWKDW¶VYLDEOHLQWKH Financial Reform. It will eventually impact this industry VKRUWRUWKHORQJWHUP" substantially, though we just don’t have enough clarity right now to know what direction it will head. (RZ) No. All we can do—and unfortunately a lot of this is reactionary—is try to make sure our systems are integrated, that they capture the proper information, (Sapient) :KDW ZHUH WKH GULYHUV IRU WKHVH QHZ and that we’re accurate and timely when reporting to the UHTXLUHPHQWV"+RZKDYHWKH\DIIHFWHGWKHJOREDO various groups. It is a pipe dream to believe that there HQHUJ\PDUNHW" is one standard report that various people want to look at. So we are reactionary—we don’t exactly know which (RZ) 7KHGULYHUVIRU¿QDQFLDOUHIRUPVWHPIURPVRPHWKLQJ direction it’s going to go. We constantly ask for more WKDWRFFXUUHGLQWKH¿QDQFLDOVHFWRU²WKHUHFHQWKRXVLQJ clarity around requirements and what we’ve done on our mortgage crisis and Credit Default Swap (CDS) trading side is spend a lot of time improving our processes. on Wall Street, which happened in the middle to late part of the last decade. And because of that crisis, and the fact that the government had to step in, we’re going (Sapient) ,V WKHUH DQ\WKLQJ HOVH FRPLQJ"

CROSSINGS: The Journal of Trading & Risk Management 30 fracking techniques over the last decade or so allowing have less of an insight into as a small IPP. We participate them to tap into these large reservoirs at a fairly cheap in such organizations as EEI, as well as other trade groups, cost. As a result, natural gas prices in 2008 were over $12 to get an idea of where things are trending, but for the most in MMBtu, but have now fallen to $4 to $5 in MMBtu, part we can only run scenarios and guess the probability because of this shift on the supply side. of various things coming out of Washington, DC. Our philosophy is to manage the things you can control. To be That, coupled with the great recession, has lowered energy able to understand the value of your business, you have prices. I work for an IPP, so we’ve seen power prices to have all of your systems integrated—you have to have basically cut in half from a high in 2008, and that’s forced what we call a “central source of truth”—that is a database a lot of consolidation in our industry. We’ve seen a lot and a system that collects information from all around the of M&A activity over the last year, mostly in the last few company, and that all of the decision makers can look at months. We’ve seen Mirant and RRI combine, but we’ve it and understand what’s going on. So that’s what we do also seen a lot of smaller mergers like Calpine and Pepco. I here—we have a system, we model our assets and hedges think everyone in the energy space is going to be forced to every day and it’s connected to the front, middle, and KXQNHUGRZQDQG¿JXUHRXWDZD\WRPDNHLWWKURXJKWKLV EDFNRI¿FHVRRXUH[HFXWLYHVFDQUHJXODUO\VHHNH\UHSRUWV low-price, commodity bear market. that give them an understanding of how the company’s changing.

(Sapient) :KDW FDQ FRPSDQLHV GR WR SUHSDUH As part of our strategy, we make sure we have enough WKHPVHOYHVIRUWKHVHUHJXODWRU\FKDQJHV" balance-sheet liquidity to support the hedges that we put on—so we model how much hedges can move and how (RZ) They have to think about it as more than just much a potential balance sheet could be used over the regulatory changes, because companies are subjected to tenor of our hedge portfolio. many different types of risk. That’s an important point I’d like to highlight for what What’s exciting about the energy industry is that we’re people can do to improve the company—and by improve I dealing with the most volatile commodities on earth. don’t just mean revenue. Companies need to understand Natural gas prices can move between $12 and $4, and the risk they’re subjected to, so you measure the risks, you maybe even back up to $12, within a year or two. Power talk about them, and you develop a strategy to improve prices can move around even more substantially. You your revenue and reduce your risk. I think that’s the key have a certain amount of market risk just being in the message that folks can think about. industry.

Whether you own assets or are a proprietary trading shop, (Sapient) ,V WKHUH DQ\WKLQJ HOVH JRLQJ RQ LQ WKH 2008 proved that you have to have your eye on credit risk. LQGXVWU\ WKDW¶V UHODWHG WKDW ZH KDYHQ¶W WDONHG :KHQ,¿UVWVWDUWHGDW'\QHJ\,QHYHUZRXOGKDYHJXHVVHG DERXW" that I would have to be worried about Bear Stearns and Lehman Brothers and various other banks and their credit (RZ) I think those are the big shifts we see right now. ratings as an IPP. So, credit ratings are another something There are new energy sources like wind and solar energy, we look at. Our business strategy relies on folks trading and those will likely become an even greater part of the in and out of these markets and the subsequent ebbs future power generation supply stack. We’re just not sure DQGÀRZV H[DFWO\KRZDQGZKHQWKH\ZLOO¿WLQ7KH\DUHVPDOOULJKW now and I think those aspects of power generation will And then you have the regulatory issues that you’re talking need to improve their technology and lower their costs about. The carbon legislation is likely at some point, and over time to be more viable. ¿QDQFLDO UHIRUP ZLOO EH KHUH VRRQ 7KHVH DUH WKLQJV ZH Rudi Zipter is Vice President of Commercial Trading at Dynegy, a power generation leader focused on delivering value to investors.

31 ASSET MANAGEMENT TECHNOLOGY AND PROCESS: alignment and evolution toward cross-asset RSHUDWLRQDOHI¿FLHQF\

Asset Managers often describe the “Holy Grail” as a technology platform that crosses all asset classes and efficiently powers business processes with minimal manual touch points. Mark Israel and Sean Smillie explain that while achieving a dynamic technology platform is difficult, it is possible for asset managers, providing they take certain steps.

Today’s asset management industry is faced with A Dynamic Technology Platform increasingly demanding clients, more complex operational A dynamic technology platform accommodates all asset requirements, growing volumes of transactions, and classes and business areas by providing a single process reduced budgets. The introduction of Undertakings for stream through various operational functions. Although Collective Investment in Transferable Securities (UCITS the theory is considered ideal, asset managers agree there IV) and Financial Regulation in the U.S. means that is no solution currently available that will meet all of their operational and technological solutions must not only business process and strategy needs. PHHWFXUUHQWQHHGVEXWDOVREHÀH[LEOHHQRXJKWRDGDSW to new regulatory changes. In spite of these challenges, However, most asset managers have numerous systems, we see leading asset managers developing a dynamic each of which accommodates one asset class and WHFKQRORJ\SODWIRUPWKDWRSHUDWHVHI¿FLHQWO\DFURVVDVVHW additional, individual custom applications linking systems classes. together. This architecture results in a lack of Straight Through Processing (STP) both in the business areas and also within the business units. The infrastructure and Current Complexity maintenance costs are high and, with little application At present, many asset managers have a variety of integration, failure points tend to arise from manual horizontal and vertical operational and technological workarounds. solutions in place that are no longer able to support their business processes. These asset managers suffer Asset managers with a legacy technology environment from poor operational support and technical integration. exhibit the following characteristics: These factors contribute not only to operational risk In some departments there is no technology system and increased costs, they also undermine operational and so the asset manager has to rely completely on SURGXFWLYLW\DQGHI¿FLHQF\ manual operations

For many asset managers, the only option to support Often, no centralized information exists and data is growing business needs is to add more complexity to static and inaccurate an already over-complicated architecture. This strategy Management reporting is complex and prone to errors results in utilizing more resources to maintain the current as data is consolidated from different sources level of service and prevents investment in solutions that FDQGULYHEXVLQHVVLPSURYHPHQWVDQGJUHDWHUÀH[LELOLW\ &RPSOLDQFH UHSRUWLQJ RQ H[SRVXUH LV GLI¿FXOW WR calculate, inaccurate, and out of date

CROSSINGS: The Journal of Trading & Risk Management 32 FIXED INCOME EQUITIES FOREIGN EXCHANGE DERIVATIVES

Portfolio SYSTEM A SYSTEM G Management SYSTEM B SYSTEM C SYSTEM H

Trading and SYSTEM D SYSTEM F SYSTEM I Execution

Middle Office SYSTEM E

Back Office SYSTEM J SYSTEM K SYSTEM L

Figure 1: Legacy Asset Management Technology State

Environmental State Model The infrastructure has separate silos for different asset FODVVHV VXFK DV VHFXULWLHV FDVK ¿[HG LQFRPH SURGXFWV In order to move from the existing state to an environment alternative investments, structured investments, and that has a dynamic technology platform, an asset manager funds. Static reference data is held on legacy systems and PXVW ¿UVW XQGHUVWDQG WKH VWDWH RI KLV RU KHU FXUUHQW is not located in one centralized area. No system can easily LQIUDVWUXFWXUH 7\SLFDOO\ WKHUH DUH ¿YH VWDJHV WKURXJK provide a client with a consolidated portfolio across all which an asset manger must evolve before reaching the asset classes. During this stage of development, an asset ¿QDOGHVLUHG VWDWH±DQ HQYLURQPHQWWKDW LVVFDODEOH DQG manager often uses a number of third-party vendors that adaptable. provide custom data feeds, which may not necessarily be Stage I: Legacy aligned to the asset manager’s existing infrastructure. Legacy system endowment within asset managers is Many processes often require manual workarounds, with characterized by multiple systems across business and a resultant increase in operational risk. operational areas. Operations are poorly integrated and Stage II: Platform Investment processes are heavily reliant on manual intervention. The At this stage, asset managers are making major investments budgetary spend in this area is used to maintain the status in their systems, introducing new applications, or quo and provides little, if any, growth or expansion of outsourcing an element of their operations. This service. Operational teams generally exceed capacity, with investment focuses on the consolidation of current service levels only maintained by increasing headcount to systems and operational processes—for example, the cope with current and future business expansion. introduction of central trade capture or common middle- RI¿FHIXQFWLRQVDFURVVDOODVVHWFODVVHV 7HFKQRORJ\FRVWVDUHGLI¿FXOWWRPHDVXUHDVWKHUHGXFHG cost of the legacy system is offset by the need for stopgap Operational capacity is still likely to be exceeded; hence, solutions to immediate business requirements. With the further investment is needed to cope with future business strong likelihood of manual data re-keying, errors are high expansion. compared to more streamlined solutions. This pressure only increases as the business expands.

33 A large portion of an asset manager’s budget is needed Stage V: Scalability to implement new systems, both from an application 7KH ¿QDO VWDJH LQ WKH SURFHVV LQGLFDWHV DQ DGRSWLRQ RI perspective and to optimize the support for operational technology-enabled business operations, resulting in high processes. Organizations at this stage, which have either OHYHOVRIHI¿FLHQF\DQGHIIHFWLYHQHVV$VVHWPDQDJHUVFDQ overspent or reduced the scope of investment, will be left easily adapt to industry changes, either driven by business in an interim state of systems progression. There is a risk expansion or regulatory requirements. Operational costs that although platform investment is made, the investment not only meet current requirements but enable ongoing will not alleviate the increasing pressure on operational investment to ensure the current level of service is teams. This situation may result in the business not seeing maintained. DVXI¿FLHQW5HWXUQRQ,QYHVWPHQW 52, VORZLQJRUHYHQ stopping the asset manager from moving to the next The asset manager has a centralized static data evolutionary stage. architecture, which is well controlled and has automated feeds into all systems. At this level, systems and operations Stage III: Steady State EHFRPH D UHDO GLIIHUHQWLDWRU DQG KHOS FUHDWH VLJQL¿FDQW By the third stage, asset managers are seeing continued added value. ROI within their current business models. Operational FDSDFLW\ LV PDQDJHDEOH DQG LW DOORZV ¿UPV WR VXSSRUW D steady level of business expansion. Costs are still high Moving Toward a Cross-Asset Solution EXW FRPSDQLHV EHQH¿W IURP WKH LQYHVWPHQW DQG VHH DQ Once the decision to develop a cross-asset class platform HI¿FLHQWHQGWRHQGSURFHVV has been made, the most sophisticated institutions will implement a phased technology and operational $W WKLV VWDJH RWKHU EHQH¿WV LQFOXGH LQFUHDVHG DFFXUDF\ transition. and improved timeliness of data. These processes give EXVLQHVV XVHUV JUHDWHU FRQ¿GHQFH LQ WKH LQIRUPDWLRQ Phase One being provided. 7KH ¿UVW SKDVH LV WR FRQVROLGDWH SRUWIROLR PDQDJHPHQW

across business units in order to provide a common Although the level of business expansion is supported VROXWLRQDWWKH¿UVWVWDJHRIWKHIURQWRI¿FHDUHDPDNLQJ by the infrastructure, any core strategy changes, or new it possible to view full exposure across asset classes within regulations, require a high level of investment. The steady a single application. As there are only manual processes in state has a high risk of dropping back toward the legacy WKH¿[HGLQFRPHWUDGLQJDQGH[HFXWLRQDUHDLQWURGXFLQJ state, unless further investment to maintain the current a common system is considered low impact from an service level is made. organizational perspective. Stage IV: Optimization Also, in Phase One, functionality is developed so that $VVHWPDQDJHUVDUHVHHNLQJWRPDNHDGGLWLRQDOHI¿FLHQF\ information can be automatically delivered from the improvements beyond the steady state and are expecting portfolio management system to the trading and execution to reduce operational costs, errors, and headcount. At this systems, reducing manual processes. stage, asset managers are also able to adapt to market and operational changes, and concentrate budgets on moving WRZDUGWKH¿QDOVWDJHRILQIUDVWUXFWXUHGHYHORSPHQW

CROSSINGS: The Journal of Trading & Risk Management 34 FIXED INCOME EQUITIES FOREIGN EXCHANGE DERIVATIVES

Portfolio Management SYSTEM A

Trading and SYSTEM D SYSTEM F SYSTEM I Execution

Middle Office SYSTEM E

Back Office SYSTEM J SYSTEM K SYSTEM L

Figure 2: Phase One - Consolidation of Portfolio Management

Phase Two 'XULQJ 3KDVH 7ZR WKH PLGGOH RI¿FH LV FRQVROLGDWHG escalation, and investigation queues across asset classes. DFURVVWKHDVVHWFODVVHV7KHPLGGOHRI¿FHSODWIRUPPXVW $VVXFKLWLVLPSRUWDQWWKDWPLGGOHRI¿FHVWDIILVFURVV KDYHIXQFWLRQDOLW\WRJHQHUDWH3UR¿WDQG/RVV 3 / HUURU asset class trained.

FIXED INCOME EQUITIES FOREIGN EXCHANGE DERIVATIVES

Portfolio Management SYSTEM A

Trading and SYSTEM D SYSTEM F SYSTEM I Execution

Middle Office SYSTEM E

Back Office SYSTEM J SYSTEM K SYSTEM L

Figure 3: Phase Two - Creating a Common Solution for the Middle Office

35 FIXED INCOME EQUITIES FOREIGN EXCHANGE DERIVATIVES

Portfolio Management SYSTEM A

Trading and SYSTEM D SYSTEM F SYSTEM I Execution

Middle Office SYSTEM E

Back Office OUTSOURCED

Figure 4: Phase Three - Outsourced Back-Office Solution

Phase Three from a legacy system to a state-of-the-art platform. Asset During this phase, an application is developed that managers should aim to improve their current state, SURYLGHV D VLQJOH IURQWRI¿FH VROXWLRQ IRU ERWK SRUWIROLR PRYLQJWKURXJKWKH¿YHSKDVHVRIWKHHQYLURQPHQWDOVWDWHV management and trading and execution. Complexity in RYHUWKHQH[WWKUHHWR¿YH\HDUV$VVHWPDQDJHUZKRGR LQWHJUDWLRQWRWKHPLGGOHRI¿FHLVUHGXFHGDVWKHUHLVRQO\ not invest in building out their cross-asset class platform one system to which other systems need connect. QRZZLOO¿QGLWYHU\GLI¿FXOWWRFRPSHWH VXFFHVVIXOO\ LQ the foreseeable future. Outsourcing will reduce costs and, at this stage, can be implemented easily because there is a high degree of Mark Israel STP and single application solutions are deployed across a Vice President based in business areas. Hence, integration to the outsourcing Boston, leads Sapient’s global buy-side practice. He has more solution becomes much simpler than outsourcing the than 20 years’ experience in legacy system. The usual outsourcing decision process asset management technology, will be made at this stage. delivering solutions that map to the business architecture and improve both operational and user efficiency. Moving Forward: Improve Your Current State [email protected] Leading asset managers understand the importance of addressing the many operational and manual processes Sean Smillie inherent in the industry. Building a dynamic cross-asset a Director based in London, leads Sapient’s European buy-side class platform is one way to tackle these issues. However, practice. With more than 20 years’ in order to build the platform, asset managers must experience delivering business- understand where they are in terms of infrastructure focused technical solutions to the and operational development, so that they can prioritize financial services sector, Sean and project-manage the implementation of their target helps provide front-office solutions VWUDWHJ\ DQG VSHQG 7KHUH DUH ¿YH SKDVHV RI HYROXWLRQ to investment management, wealth management, and hedge fund firms. [email protected]

CROSSINGS: The Journal of Trading & Risk Management 36 OMS EVALUATION: accommodating asset managers’ evolving needs

An Order Management System (OMS) is a key component of buy-side infrastructure and, if properly maintained, can significantly improve operational efficiency and risk management. However, in today’s dynamic marketplace, it is very difficult for managers to remain confident that they have the “correct” OMS in place for their evolving business, regulatory, and technology needs. Kevin Masso and Anurag Mathur present the case for conducting periodic OMS feasibility reviews and outline key considerations for selecting and/or implementing a new system.

7KH 206 LV D FULWLFDO IURQWRI¿FH V\VWHP WKDW QRZ key OMS differentiators in today’s marketplace tend commonly handles the full trade lifecycle from order to revolve around “smart” order routing or low-latency generation through to settlement. It also aggregates trading. Seamless integration with other systems to data from multiple sources and routes completed orders enhance an OMS’s out-of-box functionality, or introduce to downstream systems. As OMSs have evolved to QHZIXQFWLRQDOLW\LVDOVRFULWLFDODVWKHPDMRULW\RI¿UPV become fundamental platforms for successful business DFFHSWWKHUHDOLW\WKDWWKHUHLVQRVLQJOHVRXUFHIURQWRI¿FH operations, they are also now considerably more complex. solution provider. Not only has the market structure advanced, the volume and complexity of instruments traded by a typical asset From time to time, prudent managers question whether manager has increased over the past two years. Many their existing OMS is equipped to meet ongoing business ¿UPV SUHYLRXVO\ FRQGXFWLQJ VWUDLJKWIRUZDUG VWUDWHJLHV needs and help them maintain competitiveness. The QRZ URXWLQHO\ WUDGH GHULYDWLYH DQG H[RWLF ¿[HG LQFRPH question may arise as a result of an external or internal instruments. In order to facilitate the trading of these audit that reveals a lack of adequate internal controls, sophisticated products, an OMS must: an increase in the number of trade errors, complaints IURPWKHIURQWRI¿FHRISRRUIXQFWLRQDOLW\DUHYLHZRIWKH ,QWHJUDWHZLWKPLGGOHRI¿FHEDFNRI¿FHDQGUHSRUWLQJ systems in use, or the effects that upgrading or replacing data warehouse systems another system may have on the existing OMS. Regardless Connect to numerous brokers, liquidity pools, and of the reason, managers should periodically evaluate the settlement systems effectiveness of their current system against a desired future state and conduct the assessment with a thoughtful, Comply with global regulatory rules, as well as new pragmatic approach. standards for transparency and accountability

The impetus to undertake an internal OMS evaluation Differentiating OMS Platforms may lead to various decision scenarios. For example, VKRXOGWKH¿UP The growing number and increasing complexity of instruments traded on an OMS, along with mounting Remain with the status quo? risk and regulatory mandates, have led to a natural Switch from a proprietary system to a vendor package? industry transition toward technology-driven trading platforms that drive speed and functionality and facilitate Upgrade their existing package to the latest release? ZRUNÀRZLQWHJUDWLRQ6LQFHWHFKQRORJ\LVWKHNH\HQDEOHU Switch from one vendor package to another? to address complex marketplace requirements, it is also the key differentiator among OMSs. All OMS vendors Consolidate onto a single package across all security can provide basic buy and hold equity functionality. The W\SHVWUDGHGE\WKH¿UP"

37 As managers assess the functional and technical viability In addition to base functionality, the ease of application of their existing OMS to determine the future-state trading integration should also be a consideration—particularly environment that is best suited to their business needs, ZKHQD¿UPXVHVPXOWLSOHYHQXHVIRUWUDGHH[HFXWLRQDQG the primary areas of review may include: has installed an Execution Management System (EMS) as part of its trader desktop. The OMS typically facilitates Functionality (required vs. offered) such compute-intensive tasks as order generation, 7HFKQRORJ\ ¿UPVWDQGDUGVYVYHQGRUVXSSRUW FRPSOLDQFH DQG PLGGOHRI¿FH SURFHVVLQJ ZKHUHDV WKH EMS is a lightweight tool that allows traders to execute Current and future regulatory requirements sophisticated trading strategies quickly. The current Risk management trend is to tightly integrate the OMS and the EMS. As Total Cost of Ownership (TCO) such, many OMS vendors are attempting to add execution management to their functionality suite, just as EMS vendors are attempting to provide traditional order- Areas of Assessment management functionality. Current and Future Regulatory Requirements Functionality $OWKRXJKWKHUHJXODWRU\HQYLURQPHQWIRUEX\VLGH¿UPV The functionality required in any OMS is driven by the LVLQDVWDWHRIÀX[PRVWSUDFWLWLRQHUVDURXQGWKHJOREH needs of the end users and must deliver the minimal agree that the OMS will remain critical to enforcing functionality set required for the business to survive and IURQWRI¿FHUHJXODWRU\PDQGDWHV$VVXFKLWLVLPSRUWDQW thrive. This functionality can span a number of areas based that an OMS includes the functionality to handle on user requirements and typically includes representation future regulatory changes. To assess any OMS’s ability, IURP SRUWIROLR PDQDJHPHQW WUDGLQJ FRQWURO ¿QDQFH simply look at how it has handled recent changes, such regulatory, and operations groups. Users may request DV UHVWULFWLRQV RQ VKRUW VHOOLQJ WKH VWRFN RI ¿QDQFLDO enhancements to handle expanding asset class coverage, VHUYLFHV¿UPV streaming real-time market data, electronic trading and/ or execution management, performance management and 7KH 3UHVLGHQW¶V :RUNLQJ *URXS RQ )LQDQFLDO 0DUNHWV attribution, facilitation of internal controls, post-trade FUHDWHG LQ  LGHQWL¿HG GLVFORVXUH YDOXDWLRQ ULVN analytics and transaction cost analysis. Additionally, management, compliance, trading, and business specialized investment strategies, like those employed operations among the key focus areas in a best-practices E\KHGJHIXQGVDQGZHDOWKPDQDJHPHQW¿UPVW\SLFDOO\ release for the hedge fund industry. A similar Hedge Fund UHTXLUHDVSHFL¿FVHWRIIXQFWLRQDOLW\LQFOXGLQJIXQGRI :RUNLQJ*URXSDVVHPEOHGLQWKH8.SURYLGHVVWDQGDUGV funds trading or complex tax lot optimization. for industry best practices that will be maintained by the Hedge Fund Standards Board. The best-practice standards OMS vendors are constantly updating their functionality ZHUHLGHQWL¿HGLQWKHIROORZLQJDUHDVGLVFORVXUHYDOXDWLRQ VXLWH +RZHYHU PRVW ¿UPV HVSHFLDOO\ WKRVH ZKR KDYH risk management, governance, and shareholder conduct. been through upgrades in the past, will not—and should The guidance offered by the aforementioned group is a not—upgrade simply to take advantage of incremental fair indication of self-regulation by industry members in LPSURYHPHQWV 7KH QHZ RIIHULQJ PXVW ¿OO D FULWLFDO anticipation of forthcoming regulations. business need. It is also important that asset managers remain engaged with their vendors, user community, It is fair to assume that regulatory changes will necessitate and industry analysts to stay abreast of various OMS an OMS upgrade, although the scope of the upgrade is FKDQJHV )LUPV VKRXOG HQVXUH FRUH FULWHULD DUH VDWLV¿HG XQGH¿QHG7KLVXSJUDGHFRXOGEHDVVLPSOHDVFRQ¿JXULQJ prior to implementation. For example, the system should a few additional compliance rules or could involve an facilitate the trading of all or most security types, eliminate upgrade to the compliance processor—or even the entire cumbersome manual processes, provide tight internal OMS itself. An eventual upgrade is inevitable and its controls, meet regulatory requirements, and enhance risk success depends upon lessons learned from prior ones. reporting capabilities.

CROSSINGS: The Journal of Trading & Risk Management 38 Technology An area of pressing concern is the openness of the Each OMS must conform to the asset manager’s pre- application’s architecture. This openness facilitates established technology standards and overall technology integration of the OMS to both internal and external strategy. This typically includes: systems. All vendors claim an open architecture; however, there are varying degrees of openness. Supported Hardware/operating system/database management integration options typically range from direct database system technology stack loads or extracts to programmatic import/export Middleware platform facilities with validation logic, to extensible Application Programming Interfaces (APIs), to completely transparent Application delivery preference (desktop installation Service-Oriented Architecture (SOA). The more open the versus fully-hosted Application Service Provider systems, the tighter the integration; however, integration (ASP)) introduces more moving parts and more points of failure, Disaster recovery requirements all of which must be monitored and maintained.

Openness of platform architecture Risk Management *OREDOGHSOR\PHQWIDFXOWLHV Recording trade information accurately in the OMS is critical for accurate risk management. Trade capture Maintenance tolerance LVWKHPRVWVLJQL¿FDQWSDUWRIWKHOLIHF\FOH²ZLWKRXWLWD ¿UPKDVQRNQRZOHGJHRIWUDGHDFWLYLW\7KHWUDQVDFWLRQV OMS vendors offer varying options and support for each FDSWXUHGDUHIHGGRZQVWUHDPWRPLGGOHRI¿FHDQGEDFN of these areas. However, it is not uncommon for an asset RI¿FH V\VWHPV WR IDFLOLWDWH WUDGH FRQ¿UPDWLRQ SRVLWLRQ PDQDJHPHQW¿UPWRFRPSURPLVHLQRUGHUWR¿WDYHQGRU PDQDJHPHQW DQG HYHQWXDOO\ SUR¿W DQG ORVV DQG ULVN OMS into its enterprise architecture. The majority of exposure calculations. The OMS must provide the ODUJHDQGPHGLXPVL]HG¿UPVKDYHGHDOWZLWKWKHVHLVVXHV capability to manage risk reporting for each desk, as well during their initial OMS installation. However, evolving as supervise the escalation process as risk reporting is technology preferences and the narrowing of the support included in the enterprise reporting processes. provided by OMS vendors may necessitate revisiting WKLVDUHD7KH¿UPPXVWHYDOXDWHLWVWDUJHWVWDWHV\VWHP All of the popular OMS packages offer some level of risk DUFKLWHFWXUHDQGWKHPRGL¿FDWLRQVUHTXLUHGLQGRZQVWUHDP management functionality. Additionally, a number of systems to accommodate a new or revised OMS by focusing them can integrate with risk analytics vendors. As native on changes to feeds and system interfaces.

IDEAL STATE Mandate and Activities ‡&HQWUDOL]HGWUDGLQJSODWIRUP ‡&URVVIXQFWLRQDOJURXSUHYLHZV206 platform capabilities ‡$FWLYHH[HFXWLYHVSRQVRUVKLSVXSSRUW ‡206VXSSRUWVPD[LPXPQXPEHURI security types traded ‡6XSSRUWFRPSOLDQFHUXOHVDFURVV Prioritize and TRADING & Identify Business/ Implement Action Technology Needs/ global locations Plans OPERATIONS Issues

LESS THAN OPTIMAL

‡)UDJPHQWHGWUDGLQJSURFHVVHV ‡,QDGHTXDWHLQWHUQDOFRQWUROV¥ULVN Assess Operational management and reporting Effectiveness and ‡2OGHUYHUVLRQVPD\OHDGWRODFNRI Functional Needs analytics and integration with other tools/utilities ‡'LIILFXOWWRDFKLHYHHQWHUSULVHOHYHO reporting and monitoring Figure 1: OMS Review and Evaluation Process

39 TARGET STATE PLANNING & CURRENT STATE ANALYSIS VENDOR EVALUATION MODEL IMPLEMENTATION

‡$VVHVVFXUUHQWVWDWH ‡5HYLHZQHZUHYLVHGV\VWHP ‡'HWHUPLQHWDUJHWRSHUDWLQJ ‡(VWDEOLVKLQWHJUDWHG3URMHFW operating environment capabilities model and supporting Management Office (PMO) with ‡,GHQWLI\DQGSULRULWL]HJDSV ‡'HWDLOUHTXLUHGHQKDQFHPHQWV application architecture providers and respective teams and issues and impact on costs, timelines ‡'HYHORSGHWDLOHGEXVLQHVV ‡2QJRLQJYHQGRURYHUVLJKW ‡'HWHUPLQHOLVWRIIXQFWLRQDO ‡&RQGXFWGHWDLOHGHYDOXDWLRQWR requirements ‡&RGHYHORSGHWDLOHGFRQYHUVLRQ requirements identify preferred system ‡'HYHORSGHWDLOHGWHFKQLFDO project plan with service providers ‡5HYLHZFXUUHQWV\VWHP ‡'HYHORSEXVLQHVVFDVHIRU specifications for new/ ‡([HFXWHRQGHWDLOHGSKDVHG limitations future state business and upgraded application conversion and test plans ‡,GHQWLI\OLVWRIYHQGRUVDQG technical environments architecture ‡0DQDJHVFRSHFKDQJHFRQWURO associated products and issues ‡6KRUWOLVWYHQGRUVIRU ‡0DQDJHILQDOWUDQVLWLRQIURP detailed review current provider or upgrade to newer version

KEY FOCUS AREAS: TOOLS/TEMPLATES: ‡2UGHUPDQDJHPHQW ‡&ROODWHUDOPDQDJHPHQW ‡3URJUDPJRYHUQDQFHVWUXFWXUH ‡5),DQGRU5)3 ‡5LVNDQDO\WLFVDQGUHSRUWLQJ ‡6\VWHPSHUIRUPDQFH ‡&XUUHQWVWDWHSURFHVVPRGHO  ‡3URYLGHUSUHVHQWDWLRQV ‡3UHSRVWWUDGHFRPSOLDQFH ‡,QWHJUDWHWUDGLQJIRUPD[ ‡&DSDELOLW\HYDOXDWLRQV  ‡&DSDELOLW\JDSWUDFNLQJ security types ‡'HFLVLRQIUDPHZRUN ‡6FRULQJPHWKRGRORJ\ ‡3URYLGHUWDUJHWVWDWHVROXWLRQPRGHO

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Figure 2: Potential Approach for OMS Review, Remediation, and Future-State Evaluation

OMS offerings become more robust, it will make sense Making the Decision WR LQFRUSRUDWH WKLV IXQFWLRQDOLW\ LQWR WKH IURQWRI¿FH With so many factors to consider, the decisions to ZRUNÀRZ ZKLFK ZLOO DOORZ IRU ULVN PHDVXUHPHQW DW DOO evaluate the viability of an existing OMS and determine points of the trading lifecycle. next steps are not trivial. A disciplined approach with participation across business groups is required to 9HQGRUVSURYLGHDGH¿QHGVHWRIIXQFWLRQDOLW\ZKLFKWKH successfully assess trading, operations, compliance, and ¿UPPXVWHLWKHUDFFHSWRUH[WHQGWKURXJKFXVWRPL]DWLRQ WHFKQRORJ\$3URMHFW0DQDJHPHQW2I¿FH 302 PD\EH or integration. Similarly, an organization will have necessary to coordinate the overall effort. By driving the technology preferences or standards that must be aligned JURXSWRZDUGDGH¿QHGWDUJHWHQGVWDWHLWZLOOEHHDVLHU ZLWK WKH YHQGRU RIIHULQJV (DFK ¿UP GH¿QHV LWV RZQ to prepare a detailed work plan to address the transition. criteria for tracking and managing risk, but they must This type of focused approach can help the organization also conform to the regulations imposed on the markets in QDYLJDWHWKURXJKDP\ULDGRILVVXHVHI¿FLHQWO\ which they trade. Navigating this environment will require EX\VLGH¿UPVWRLQVWLOOGLVFLSOLQHDQGHPSRZHULWVSHRSOH The simple decision is to do nothing and wait for clarity to stay at the forefront of market developments. Doing so regarding pending regulatory changes and for budgets means that business and technology leaders may engage to loosen. Although this strategy may be successful in in dialogues with system providers to determine the WKHVKRUWWHUPLWLVQRWZLWKRXWULVN:KHQD¿UPIDOOV appropriate time to conduct a value-added gap analysis of multiple versions behind, the eventual upgrade will their existing systems. EH PRUH GLI¿FXOW DQG FRVWO\ )RU H[DPSOH WKH 206

CROSSINGS: The Journal of Trading & Risk Management 40 vendor may limit, or eliminate altogether, support for an Total Cost of Ownership outdated version of its product. Either may necessitate One of the challenges with reviewing and updating an inconveniently timed upgrade. What’s more, certain the OMS environment is reconciling the expenditures underserved user groups will continue to founder with required with current budget restrictions. Depending on the current offering. While it may ultimately make sense the OMS, the application delivery type, and the scope of IRUD¿UPWRUHPDLQZLWKWKHVWDWXVTXRDSUDJPDWLF¿UP functionality required, an implementation or an upgrade will perform a thorough needs-based analysis to identify can be resource intensive and quite costly. Tightened emerging business risks and functional/technological EXGJHWV FDQ IRUFH ¿UPV WR IRFXV RQ ³NHHSLQJ WKH OLJKWV requirements in order to develop and implement an action on” rather than undertaking large, complex initiatives. plan that sustains a competitive and effective organization. The bottom line is that it is important to use past upgrade In this case, leaving systems unchanged becomes a experiences to predict timelines and costs of future ones. conscious decision rather than a path of least resistance taken purely because they are unwilling to expend the It is critical to perform a thorough analysis in order to time and effort to perform the necessary analysis. accurately estimate the total cost of upgrading the OMS. This should extend beyond the purchase or lease price of When working with an OMS vendor, it is important to the OMS to include the impact to all systems it affects, approach this decision from a partnership perspective. IHHV WR FRQ¿JXUH RU FXVWRPL]H WKH 206 SURIHVVLRQDO Buy-side managers and OMS vendors must communicate services costs for all resources engaged, as well as any openly and navigate issues together. A manager must incremental infrastructure costs. The top-down strategic be aware of the functional roadmap the vendor is business and technical goals must be reconciled with pursuing (e.g., the vendor may want to add other asset the costs of deploying required functionality based on classes to the platform or incorporate additional trading DERWWRPXSDQDO\VLV2QFHWKH¿UPKDVDFOHDUYLHZRI functionality). The manager should also understand the FRVWVDQGEHQH¿WVIRUHDFKSLHFHRIGHVLUHGIXQFWLRQDOLW\ vendor’s perspective on upcoming regulatory changes. it can decide what to include or exclude. 'RHVWKHYHQGRUKDYHDVSHFL¿FUHOHDVHSODQQHGWRDGGUHVV concerns? How will this release affect the current product roadmap? Getting Started It is important for asset managers to have a short-term In order to increase the chances of successfully navigating (remain in compliance, “keep the lights on”), medium- WKHVH LVVXHV WKH 206 SODWIRUP PXVW GLVSOD\ ÀH[LELOLW\ term (consolidate to a single OMS across desks), and The vendor must have a track record for delivering long-term (move to an ASP model, outsource support) changes within a tight time frame and releasing upgrades plan for the OMS. Additionally, these priorities may quickly. It is important that the upgrade process is well change over time as the exercise becomes one of juggling understood and that the vendor has given thought to its competing demands from multiple areas. The business effects on existing customer installations. It may turn out must consider how to incorporate the trading of more WKDWDQXSJUDGHQRZWRDPRUHÀH[LEOHDQGRSHQSODWIRUP exotic instruments while avoiding fragmented processes will make it easier to incorporate future changes that and moving toward an integrated trading platform. The stem from regulatory requirements or future business costs and risks of incorporating such new technologies as a LQLWLDWLYHV$¿UPZLOOQRWZDQWWREHIRUFHGWRDGGPDQXDO 62$ZKLFKDOORZVWKH¿UPWRUHPDLQRQWKHOHDGLQJHGJH steps to its processes while it waits for a vendor to develop must be balanced against the mandate to provide platform and roll out new functionality. This issue can potentially VWDELOLW\)RUH[DPSOHD¿UPZLOOQHHGWRDVVHVVZKHWKHU RYHUEXUGHQ H[LVWLQJ UHVRXUFHV RU XSVHW WKH VWDI¿QJ PL[ upgrading to facilitate a tighter OMS-EMS integration is altogether. a must-have vs. a nice-to-have given its business model, the integration capabilities of the two systems, the costs of the integration, and competing demands on the resources involved.

41 7KHRQO\ZD\D¿UPZLOOEHDEOHWRHQVXUHWKDWDQ206 Kevin Masso ¿WV LQWR LWV SODQV DW DOO VWDJHV LV WR SHUIRUP D WKRURXJK is a Director based in New York evaluation of its situation and its options. Critical success with ten years’ experience working factors include senior management sponsorship, strong with the front-office teams and systems of buy-side asset project management, active vendor management, management firms. His area of participation from all functional groups affected, and expertise is the configuration and business user (traders and portfolio managers) buy in and integration of order management commitment to the success of the effort. Firms should systems with internal and external consider various approaches, such as proof-of-concept applications. Prior to joining installations and testing new functionality or software in Sapient Global Markets, Kevin was a Director of Implementation a pilot environment. Navigating the current environment Services at Charles River may prove challenging in the short term, but the criticality Development. RIWKH206WRWKHIURQWRI¿FHDQGWUDQVDFWLRQSURFHVVLQJ [email protected] LQJHQHUDOQHFHVVLWDWHVWKDWHDFK¿UPH[SHQGWKHHIIRUW WRXQGHUVWDQGDOOLQÀXHQFLQJIDFWRUVVRWKDWLWFDQPDNH Anurag Mathur proactive decisions that are in its best business interests. is a Senior Manager in Boston. He has more than 14 years of experience in the financial services industry, including five of which were dedicated to helping clients improve processes, reduce operational and regulatory risks, and enable strategic business initiatives. Prior to joining Sapient Global Markets, Anurag was a Manager in the Financial Services Risk Management practice at Ernst & Young LLP. [email protected]

CROSSINGS: The Journal of Trading & Risk Management 42 OTC DERIVATIVES VALUATION: adoption of multiple pricing curves

Historically, financial institutions used a single standard curve to value derivatives. Recently, however, market participants have started to move away from a single curve for both discounting and forecasting. Instead, they are using multiple curves, each playing a specific role in valuation. Forecast curves continue to be based on London Interbank Offer Rate (LIBOR), but are built specifically for different tenors. Also, a significant number of participants construct discount curves based on Overnight Indexed Swaps (OIS) rates. Kevin Samborn examines this trend.

Shortly after the onset of the recent credit crisis, market During the crisis, the assumption that each institution had participants moved away from using a single standard equal credit risk was clearly invalidated. This observation curve for valuation. Historically, all derivative valuation was plainly shown in several market trends, for example: was performed assuming a single standard curve. This methodology was based on the belief that all market The spread between LIBOR and “risk free” overnight SDUWLFLSDQWV KDG HTXDO FUHGLW ULVN WKDW WKH ¿UP FRXOG swap rates such as those based on Fed Funds (The fund itself with LIBOR, and that the embedded credit Fed Funds Effective Rate) and Euro OverNight Index risk for rates of different maturities was negligible. This Average (EONIA) widened methodology made pricing easy, since calculation libraries, The basis spread between LIBOR rates of different systems, and reports only required one curve. Trading was maturities widened as well simpler, as the hedging process required only one set of curve perturbations.

Figure 1: USD 6-month v. 3-month 5-year Basis Swaps (Source: Bloomberg Finance L.P.)

43 Market participants noticed a dramatic increase in the The underlying reasons for the move from a LIBOR- LIBOR-Overnight Indexed Swaps (OIS) spread during based curve to an OIS-based standard curve are twofold. the credit crunch. In August of 2007, this spread was First, the intense focus on collateral led the market to around 10 basis points. However, by October of 2008, understand that the discounting methodology used to following the collapse of Lehman Brothers, the spread had value derivatives must match the calculation of interest widened to 365 basis points.1 The previously negligible paid on collateral. Second, during the credit crisis, banks single currency basis swap spread between LIBOR rates of refused to lend to each other because of counterparty GLIIHUHQWPDWXULWLHVDOVREHFDPHVLJQL¿FDQW)RUH[DPSOH credit risk. This observation resulted in a perceived the 3-month vs. 6-month USD LIBOR 5-year swap spread breakdown of the reliability of LIBOR as a benchmark, as widened from a very stable sub-1 basis point spread for the it is a consensus composite. ¿UVWVL[PRQWKVRIWRDKLJKRIDOPRVWEDVLVSRLQWV in March of 2009.2 When a derivative is “in the money,” the counterparty with positive mark-to-market collects collateral from the To adapt to the new conditions of unequal credit risk, other counterparty. Interest is paid on posted collateral, market participants are adopting a two-curve framework including both bilateral ISDA Credit Support Annexes for valuing derivatives. One curve is used for discounting (CSAs) and through centrally cleared LCH.Clearnet and a curve that matches the maturity of the underlying SwapClear margin accounts. The rate used is a standard ÀRDWLQJUDWHLVVHOHFWHGIRUSURMHFWLRQ overnight rate, such as Fed Funds, EONIA, or Sterling OverNight Index Average (SONIA). These rates are Although there is consensus on the methodology for considered as close to “risk free” as possible since the constructing the forecast curve, multiple opinions exist rates exist only for a single day. This process protects for the discount curve. the positive counterparty in case of default. Since the in-the-money counterparty is paying interest on posted cash collateral, the counterparty is essentially funding the The Discount Curve position with the overnight rate. The discount curve is the foundation for all other calculations, including construction of the forecast curve. Therefore, it is natural to present value-collateralized A basic concept in all valuation is Net Present Value (NPV). derivatives with a funding curve built from OIS. Opinions 139LVWKHYDOXHRIIXWXUHFDVKÀRZVDFFRUGLQJWRWKHLU vary on how far to take the new methodology. Some worth today. This concept is derived through application participants believe that an OIS curve should be used to of a discount curve. The curve is a mathematical function discount all trades. Others believe that it should only be of discount factors for each point in time from today into used for collateralized trades with the bank’s unsecured the future. Each discount factor is the value of one unit cost of funding used for uncollateralized trades. This cost of currency at a future point in time, relative to its value of funding, however, is subjective and can lead to many today. For example, if the one-year interest rate is 3%, the different prices in the market based on relative value. Still, value of 1.0 USD in one year is approximately .97 USD others continue to use the “legacy” way, the old standby today. This is because the .97 USD can be invested at the LIBOR curve—using LIBOR deposits, futures, and swap one-year rate, and 1.0 USD will be returned. The curve rates. These banks claim that this method still captures that contains all the discount factors is referred to as the WKHPRVWHI¿FLHQWDQGOLTXLGPDUNHW:KLOHWKH¿UVWDQG discount curve. third options are attractive for their simplicity, the second option is probably the most accurate, but is much more 7RDGDSWWRWKHLVVXHWKDW/,%25QRORQJHUUHÀHFWVHTXDO subjective and complex. credit risk, many market participants are now using a discount curve built from OIS.

1 “The LIBOR-OIS Spread as a Summary Indicator”, Rajdeep Sengupta and Yu Man Tam, Federal Reserve Bank of St. Louis, Economic Synopses, 2008, Number 25. 2 Source: Bloomberg, LP, USBC1 Curncy HP, January 2, 2007 to May 26, 2010.

CROSSINGS: The Journal of Trading & Risk Management 44 As explained by Marco Bianchetti in his January 2010 way as any discount curve to calculate the present value paper, “At least two different practices can be encountered RIFDVKÀRZV in the market: a) the old “pre-crisis” approach (e.g. the depo, Futures/FRA, and swap curve cited before), that The OIS curve is stripped from quotes available through FDQEHMXVWL¿HGZLWKWKHSULQFLSOHRIPD[LPXPOLTXLGLW\ typical market data vendors, including Bloomberg and (plus a little of inertia), and b) the OIS curve, based on Reuters. OIS quotes are typically available as displayed in WKH RYHUQLJKW UDWH (21,$ IRU (85  MXVWL¿HG ZLWK Figure 2. collateralized (riskless) counterparties.”3 MAX BLOOMBERG CURRENCY UNDERLYING TENOR Like common LIBOR-based swaps, OIS swaps pay (or UHFHLYH  D ¿[HG UDWH RQ RQH OHJ DQG UHFHLYH RU SD\  D USD Fed Funds 10y ÀRDWLQJUDWHRQWKHRWKHU7KHÀRDWLQJOHJRIWKHRYHUQLJKW EUR EONIA 30y indexed swap is a daily resetting rate, such as Fed Funds RU(21,$$WPDWXULW\WKHÀRDWLQJOHJSD\VWKHJHRPHWULF GBP SONIA 30y average of the daily compounded overnight rate and the ¿[HGOHJSD\VWKH¿[HGFRXSRQ CHF TOIS 2y

JPY Uncollateralized O/N 2y As with LIBOR-based swaps, OIS are executed at par, Call Rate meaning they are worth zero at inception. The market Figure 2: Quoted OIS Maturities (Source: Bloomberg Finance L.P) for par OIS is very liquid and quotes for swap rates on several different maturities are readily available at the As noted above, the short end of the curve is liquid for short end for major currencies. It is therefore possible to major currencies. A key decision that needs to be made is use the quotes for the various maturities and to construct how to handle the OIS curve beyond liquid quotes in the a curve that matches all OIS quotes. For dates between the market. This can be done with extrapolation or some kind quoted maturities, interpolation is used as normal. Once of regression/historical correlation against the known the curve has been created, it can then be used in the same LIBOR curve.

Figure 3: USD OIS Quotes (Source: Bloomberg Finance L.P.)

3 “Two Curves, One Price: Pricing & Hedging Interest Rate Derivatives Decoupling Forwarding and Discounting Yield Curves”, Marco Bianchetti, January 2010. 45 The Forecast Curve The reason is that during the crisis, the basis spread—the VSUHDGDGGHGWRRQHVLGHRIDVZDSEHWZHHQWZRÀRDWLQJ As well as being used for all discounting, the LIBOR- index legs—between LIBOR rates of different maturities based curve was used to calculate forward rates to project also widened. For example, a USD 3-month vs. 6-month XQNQRZQ /,%25 UHVHWV IRU IXWXUH FDVK ÀRZV RQ WKH LIBOR swap will have a spread added to the 3-month ÀRDWLQJOHJRIVZDSV side. This spread is indicative of the additional credit risk carried for the longer-maturity 6-month loan. In order for 'HULYDWLYHVVXFKDVLQWHUHVWUDWHVZDSVKDYHERWK¿[HG the 3-month side to equal the 6-month side at inception DQGÀRDWLQJFDVKÀRZV7RHVWDEOLVKWKHSUHVHQWYDOXHRI (par), a spread must be added. a trade, it is necessary to obtain values for all future cash ÀRZVLQFOXGLQJÀRDWLQJFDVKÀRZV)RUZDUGUDWHVDUHDQ Before the crisis, when all credit risk was considered equal, estimation of future interest rates, given current market these spreads were negligible and typically ignored. FRQGLWLRQV :LWK ÀRDWLQJ FDVK ÀRZV DFWXDO YDOXHV DUH unknown in the future. A forward curve must therefore be There are two possible ways to bootstrap, or build, XVHGWRHVWLPDWHWKHIXWXUHÀRDWLQJUDWH forecast curves for each LIBOR tenor. The preferred and most direct way is to choose instruments that use As noted above, before the crisis, it was easy and the underlying of the proper tenor for the entire curve. straightforward to use one curve for both discounting For example, to strip the 3-month USD LIBOR curve, DQG SURMHFWLQJ IRUZDUG UDWHV 7KH VLPSOL¿FDWLRQ PHDQW choose USD swaps that pay 3-month LIBOR. To strip the that one curve was logically used twice. However, the 6-month USD LIBOR curve, choose USD swaps that pay perception was that only one curve was required, and 6-month LIBOR. market participants typically used the same LIBOR-based discounting curve to calculate forward rates. Since we However, the instrument quotes may not be available or now should use the OIS curve for discounting, a forecast there are not enough liquid instruments for the entire curve for projection is still required. This should still be a curve. The alternative is to strip a “base” LIBOR curve LIBOR curve, but we need to make sure it is constructed (using the de facto vanilla tenor) along with a spread consistently with the OIS discount curve. built from basis swaps. For example, to strip the 1-month FXUYHIRU(85¿UVWEXLOGD(85,%25FXUYHXVLQJGLUHFWO\ In addition, separate forecast curves must now be quoted 6-month EURIBOR swaps, and then construct a FRQVWUXFWHG IRU HDFK /,%25 WHQRU XVHG LQ ÀRDWLQJ UDWH spread curve built from 6-month v. 1-month EURIBOR derivative legs. For example, swaps indexed with 3-month basis swaps. The 6-month curve is then used to forecast LIBOR must use a different forecast curve than those 6-month EURIBOR and the 1-month curve is used to indexed with 6-month LIBOR. forecast 1-month EURIBOR.

CROSSINGS: The Journal of Trading & Risk Management 46 Figure 4: USD 6-month Basis Swaps (Source: Bloomberg Finance L.P.)

A key issue currently being debated in the market is System and Procedure Requirements whether the swap quotes themselves use OIS discounting To fully implement the changes needed to address new or the traditional LIBOR-based discounting. Our post-crisis market conditions, it is important to ensure observation is that vanilla swaps are quoted assuming that valuation methods, systems, and reports can handle OIS funding. Since interdealer vanilla swaps are centrally both a discount curve and a forecast curve. cleared at LCH.Clearnet SwapClear, this is consistent with the view that collateralized trades should be discounted Wide-scale adoption of OIS-based discount curves and with OIS. multiple forecast curves is still in its early days. Among dealers that choose OIS discounting, some report all This issue is also observed by Bloomberg: “Assuming that pricing carried out systematically with full integration into quotes received by Bloomberg from interdealer brokers systems. Others employ OIS-based curves on an ad-hoc pertain to swap transactions between dealers (that basis on the trading desk and are carrying out IT projects have stringent mutual bilateral credit-support annex in order to systematically accommodate their use. agreements in place), it makes sense to modify stripping/ bootstrapping methods to assume OIS discount factors Changing systems and procedures can be challenging. instead of LIBOR discount factors.” Although such leading commercial systems as Murex, Calypso, and Summit have long technically supported The net effect on forecast curve bootstrapping is that separated discount and forecast curves, proprietary an OIS-based discount curve should be constructed systems need to be adapted to accommodate multiple ¿UVW7KLVGLVFRXQWFXUYHVKRXOGWKHQEHLQFOXGHGLQWKH curves. Analytics software vendors are also upgrading their bootstrapping process to discount the swap instruments offerings to incorporate the multiple curve framework for used to build the forecast curve. valuing exotics using sophisticated option pricing models.

47 Perhaps more complex than systems updates, is the need To compile the estimate of the effects of switching WR DGDSW PLGGOH DQG EDFNRI¿FH SURFHGXUHV WR PXOWLSOH discount curves, an OIS-LIBOR spread is then used to FXUYHVZKHQWKH\ZHUHVSHFL¿FDOO\GHVLJQHGWRVXSSRUWD multiply the sensitivities along the curve. The total is an VLPSOL¿HGVLQJOHFXUYHIUDPHZRUN)LUVWHYHQZKHQV\VWHPV approximation of the effects of switching from LIBOR to FDQWHFKQLFDOO\VXSSRUWPXOWLSOHFXUYHVWKHFRQ¿JXUDWLRQ an OIS-based funding curve. needs to be changed for each curve, as well as the pricing policies and model setup. As such, it can be challenging to When the new OIS curve is used to revalue the book, the identify which trades are collateralized and which are not. new valuations are compared with the estimate and any Next, market data needs to be loaded for a greater number discrepancies are investigated. of instrument quotes, perhaps even involving new sources. 7KHPLGGOHRI¿FHQHHGVWREHSUHSDUHGWRDQDO\]HPDUNHW A similar approach is used to evaluate the effects of the data exceptions and P&L explanation when multiple curves forecast curve. are in place. Also, any reports that assumed a single yield curve must be updated. Embracing Change In addition, most of the work so far has been on relatively 7KHFUHGLWFUXQFKKDVFOHDUO\KDGPDMRUUDPL¿FDWLRQVRQWKH vanilla interest rates products. Systems and procedures FRQGXFWRIWKH¿QDQFLDOLQGXVWU\2QHRIWKHUHVXOWVLVWKH for exotics and such asset classes as equities, credit, way sophisticated institutions have challenged the means foreign exchange, and commodities must all be adapted by which vanilla interest rate swaps are valued based upon to support the new discount curve (and forecast curves as the issue of unequal credit risk. As this new methodology applicable). is being implemented and understood, it is important that less-sophisticated institutions also understand WKHFKDQJHV,WLVQRWWKH¿UVWWLPHWKDWWKHPDUNHWKDV Testing the New Approach witnessed a change in a standard methodology—a similar To test the effects of the new curves on valuation, scenario also occurred at the height of the crisis in the participants typically calculate sensitivities to the various structured credit market, when traders moved away from curves and then estimate the effect of the new curve. After *DXVVLDQFRSXODIRUYDOXLQJVXSHUVHQLRUWUDQFKHVLQWKHLU revaluing the book, the new value is compared with the correlation book. However, what past history has shown is HVWLPDWHDQGDQ\GLIIHUHQFHVDERYHDVSHFL¿HGWROHUDQFH that changes in methodology can be very costly if ignored are investigated. DQGZKLOHWKHV\VWHPDQGEDFNRI¿FHPD\EHH[SHQVLYHWR change, ignoring these new market developments could The estimate is typically calculated with a Taylor be even more costly. approximation using sensitivities to both the funding and forecast curves. This requires an implementation where a Kevin Samborn single curve is used, but applied in two roles as a discount is a Director based in Boston curve and a forecast curve. focused on valuation and risk management initiatives. Before The curve is perturbed by bucket and sensitivity and joining Sapient he worked at Numerix, a pricing analytics is calculated for both discounting and forecasting. The software company, specializing in sensitivity buckets are then stored at either the trade or structured notes and their hedges. portfolio level. [email protected]

CROSSINGS: The Journal of Trading & Risk Management 48 ENERGY RISK MANAGEMENT: toward a consistent approach

Tony West and Sunilkumar Ramakrishnan argue that energy trading companies require a more consistent approach to monitoring, measuring, and managing market, credit, and operational risks.

Most energy trading companies exhibit common Learning from Banks’ Errors characteristics when it comes to their risk management 7KHUHFHQW¿QDQFLDOFULVLVUHYHDOHGPDQ\ÀDZVLQKRZEDQNV approach: different types of risk, such as credit or market approach risk management. Many critics and regulators risk, are managed by separate departments. Operational believe that banks lacked an accurate understanding of risk is largely overlooked while credit and market risk exposures and the correlation of their portfolios to macro- typically command most of a risk manager’s time. Most economic factors. Also, risk measurement was highly risk managers spend much of their time monitoring risk, UHOLDQWRQFUHGLWUDWLQJDJHQFLHVDQGWKHUHZDVLQVXI¿FLHQW less time measuring it, and an even smaller amount of time focus on stress-testing portfolios, using both historical and actively managing it. As such, there is substantial room forward-looking scenarios. for energy companies to improve their risk-monitoring processes and, in doing so, they would do well to heed Investment banks have started scrutinizing their portfolios the investment banking industry’s risk management more carefully, making use of robust, back-tested, mistakes. independent modeling techniques. As a result, banks are gaining a true understanding of their risk exposure and there is greater accuracy than before. Banks are conducting Room for Improvement stress tests more frequently, including sensitivity tests There are a number of compelling reasons why energy with risk variables that extend beyond “normal” moves. trading companies should improve the consistency of their Scenario tests, where historical and extreme events risk management processes, including: are modeled and used to stress the portfolio, are also Preparing for and safeguarding against the impact of an HPSOR\HG,PSRUWDQWO\¿QDQFLDOLQVWLWXWLRQVKDYHUHDOL]HG investment bank or energy trading company failure

Reassuring shareholders that they understand potential risks

Improving risk management, since it opens up access to investment capital, which fosters growth MANAGE

Ensuring regulatory preparedness, since regulatory attention is increasingly targeted at commodities CREDIT MARKET MONITOR RISK RISK It is advisable for energy companies to help shape the future of the industry rather than be on the receiving end OPERATIONAL of any onerous new rules that may arise as regulators shift RISK their focus toward energy risk management. For example, the Commodity Futures Trading Commission (CFTC), has already proposed new measures, including possible MEASURE position limits on energy contracts. These and other proposals may force energy companies to reevaluate their risk management procedures, monitoring processes, and potentially, their business strategies. Figure 1: Consistent Tools and Techniques Can Help Determine How Risks Overlap, Interact, and Impact the Business

49 that relying mainly on one risk measure, such as Value at control center. Firms active in the gas markets might 5LVN 9D5 LVLQVXI¿FLHQWSDUWLFXODUO\DVWKHDVVXPSWLRQV ZLVK WR XQGHUVWDQG WKH HIIHFWV RI D VLJQL¿FDQW WUDGLQJ underlying VaR analysis break down where extreme disruption at a gas hub or the loss of a large storage facility. events are involved. As a result, banks are now looking at a Whichever stress scenarios are used should be reviewed combination of VaR analysis, stress test results, including UHJXODUO\DQGDGMXVWHGWRUHÀHFWFKDQJHVWRWKHFRPSDQ\¶V “what if” scenario modeling, and, reverse stress testing. circumstances.

The scenarios outlined above may be thought of as extreme Market Risk situations, but planning for each is a good idea. Until Risk managers at energy trading companies tend to recently, few would have thought that a cloud of volcanic be skilled at monitoring and measuring market risk. ash could have caused such disruption and led to heavy However, energy businesses need to adopt a much more ¿QDQFLDO ORVVHV LQ WKH DYLDWLRQ LQGXVWU\ $V VXFK VWUHVV active approach toward the management of market risk testing enables businesses to determine their readiness DQGHI¿FLHQWXWLOL]DWLRQRIULVNFDSLWDO to deal with extreme events. It allows them to more accurately understand the risks they face, to be better Energy trading companies should identify any risks prepared, and provide investors with a clearer picture of not captured in their current risk management or VaR the risks involved in the business operation. frameworks and include these in the program list for prioritization. A consistent process will improve the Finally, regular back testing should be performed. This completeness and quality of risk management, and reduce SURFHVVLQYROYHVFRPSDULQJWKHSUHYLRXVGD\¶V3UR¿WDQG the requirement for manual intervention. Loss (P&L) with daily VaR numbers. This is important from a regulatory point of view and is also essential to Furthermore, energy companies must make greater use of HQVXUH FRQ¿GHQFH LQ ULVN PDQDJHPHQW SURFHVVHV 6WHSV stress testing in order to more dynamically manage market should be taken to ensure that the number of exceptions— risk. Stress testing must become a regular part of their risk- losses larger than estimated by the VaR model in modeling process and not simply a standalone measure. frequency and size—are understood and corrective actions Stress testing should incorporate varying probability are incorporated into the risk-management model. Back ZHLJKWVVRWKDW¿UPVJDLQDEHWWHUXQGHUVWDQGLQJRIWKH testing of expected tail loss can also provide an indication risk range and include historical scenarios, such as the of how well the model captures the size of expected loss oil price crash of 2003. Running sensitivity tests can be EH\RQGWKHWUDGLWLRQDORU9D5FRQ¿GHQFHOHYHOV useful as well. For example, these tests can help companies discover the impact of such events as a 50% drop in oil prices or a breakdown of price correlations. In addition, Credit Risk ¿UPV FRXOG FRQVLGHU WKH LQWURGXFWLRQ RI ³EODFN VZDQ´ Traditionally, while credit risk is an important testing—stressing a portfolio with a previously consideration, the main focus within energy trading ignored or considered to have little likelihood of occurring. companies is monitoring counterparty credit risk and For example, the Euro losing its currency status or the limiting counterparty exposure by applying credit lines. cutting off of Russian gas supplies to Europe. 0RVW RI WKH LQLWLDWLYHV WDNHQ WR LPSURYH HI¿FLHQF\ LQ this area have been aimed at optimizing this credit risk 'H¿QLQJZKLFKW\SHRIVFHQDULRVHQHUJ\FRPSDQLHVVKRXOG PRQLWRULQJSURFHVV:KLOH¿UPVDUHVNLOOHGDWPRQLWRULQJ model is not straightforward. The scenarios chosen should credit risk, they still need to improve the way credit EHXQLTXHWRHDFKFRPSDQ\DV¿UPVQHHGWRXQGHUVWDQG risk is measured and adopt a proactive approach to its what factors are most critical to their own business management. models. Oil companies, for example, could ask themselves what would happen if the crude oil price fell to $10/bbl, Many energy trading businesses only measure credit liquidity within the oil market completely dried up, or oil risk as a current exposure, while giving little attention to assets were seized by local governments. In the case of Potential Future Exposure (PFE). PFE methodology has power companies, a comparable scenario might be the been improved and is now measured using Monte Carlo, discovery of a type-fault in a nuclear power station or variance/co-variance, and other techniques dependent the failure of the Transmission System Operator’s (TSO) upon the trading portfolio.

CROSSINGS: The Journal of Trading & Risk Management 50 40 35 30 25 Outlier 20 15

9D50LOOGD\ 10 5 0 0 200 400 600 800

Exposure Mill $

Figure 2: Identification of a Large Risk Deviation

Energy trading companies need to more actively manage ,Q RUGHU WR PDQDJH FUHGLW ULVN HYHQ PRUH HI¿FLHQWO\ credit risk. Firms should invest in capabilities that allow energy trading companies also need to rethink their managers to drill down into risk results in real time. attitude toward collateral. At present, collateral tends to be 7KHVH FDSDELOLWLHV KHOS ¿UPV JDLQ DQ XQGHUVWDQGLQJ RI YLHZHGE\PRVWHQHUJ\¿UPVDVVWDWLFGDWD)RUH[DPSOH both the contributors to risk and insight into where it is a company sells crude oil to another market participant, concentrated. They also enable companies to identify ZKLFK KDV SRVWHG P LQ FROODWHUDO 7KH ¿UVW FRPSDQ\ positions or trades that place a counterparty outside the views this collateral value as a credit risk offset, but normally acceptable limits of risk. Such credit exposures ignores that fact that the value of the collateral changes can then be hedged by trading credit default swaps, helping as the market moves. If the market moves adversely, not the company realize value from price arbitrage between only does the collateral value have the potential to fall, the the various counterparty credit spreads. This approach is exposure to the market participant increases, creating an often used by investment banks. even greater degree of credit risk. This process is often ignored by energy companies and, as a result, exposes Companies need to identify deviations from approved risk them to a risk they are not measuring. distribution policies by identifying high-risk counterparties and actively managing marginal credit risk on a daily In addition, energy trading companies must ensure that basis. The company could reduce risk by going long credit changes to counterparty exposure due to macro-economic default swaps against the high risk counterparty and factors are understood and appropriately modeled. possibly bring VaR to consistently lower levels, without Systems and procedures should be upgraded so that KDYLQJWRORVHRXWRQWKHEHQH¿WVRIGHDOLQJZLWK³KLJKHU the volatility in the collateral and macro impacts can be risk” market participants. The company could also choose measured, monitored, and managed. This process will to bring the VaR back in line using other routes, including ensure that the correct offset to credit risk exposure is the use of central clearing, netting, identifying a natural used in credit risk calculations. hedge, by asking for additional collateral, or even exchange trading. Clearly, there are a number of possible avenues Finally, as in the case of market risk, energy trading the company can take, however, the essential point is that FRPSDQLHV FDQ LPSURYH WKH HI¿FLHQF\ RI WKHLU FUHGLW it must actively manage VaR from an informed position. ULVN PDQDJHPHQW SURFHVVHV E\ ¿UVW FDSWXULQJ DQ\ ULVNV not already included in their current risk-management frameworks, and, second, through back testing.

51 )LQDOO\ IRU ¿UPV RSHUDWLQJ LQ WKH SK\VLFDO FRPPRGLWLHV arena, other types of operational risk should be considered. Trading liquidity risk is an area that overlaps with market ,QSDUWLFXODUEXVLQHVVHVQHHGWRDVVHVVWKHHI¿FLHQF\ZLWK DQGFUHGLWULVNDQGLVDQRWKHU¿HOGLQZKLFKFRPSDQLHV which physical assets operate. In this respect, metrics should consider introducing a more consistent approach aimed at measuring the commercial availability of an asset to monitoring, measuring, and managing risk. If liquidity can also play an important role. Indeed, some large energy falls when an energy trading company is carrying out a ¿UPVDOUHDG\PDNHXVHRIWKHVHPHWULFV)RUEXVLQHVVHV transaction or holding an open position, and the company that do not yet carry out these assessments, forming buying cannot unwind or hedge the position fast enough, partnerships with agencies that benchmark operational liquidity risk is created. Investment banks actively manage SURFHVVHVFDQSURYHEHQH¿FLDO trading liquidity risk by monitoring the market bid-ask spreads and building this into their market-making and pricing models. Energy companies need to consider this aspect and build a charge into their pricing models, both A Consistent and Holistic Risk Approach WRDYRLGIDOOLQJLQWRDOLTXLGLW\WUDSDQGWRPRUHHI¿FLHQWO\ 7RGD\¶VHQHUJ\WUDGLQJ¿UPVPXVWWDNHDFRQVLVWHQWDQG manage trading liquidity risk. holistic approach to risk management. In particular, companies must abandon old attitudes that separate market, credit, and operational risk and view operational Operational Risk ULVNDVWKH³SRRUUHODWLYH´RIWKHRWKHUWZR,QFRQWUDVW¿UPV need to determine where the risks overlap and quantify Operational risk management is in an immature state at these interactions in a consistent manner. Companies most energy trading companies and only some are now must become more sophisticated in the measurement beginning to monitor trading operational risk. Indeed, of risk, and more active in its management. Finally, the industry is only just becoming aware of the need to businesses should ensure that similar tools and techniques use benchmarks or metrics to measure and understand are employed across all types of risk, in order to ensure its operational risk. As with other risks, proper management consistent management and provide an enterprise-wide is impossible without an adequate means of measuring view of risk. and monitoring.

2QH DUHD RI SDUWLFXODU ZHDNQHVV LV WUDGH FRQ¿UPDWLRQ The process is riddled with delays and, even at large Tony West companies, can take several weeks depending upon the is a Director based in London. Prior to joining Sapient, he held complexity of the transaction, issues encountered in the front-office trading and senior contract terms, and so forth. If a counterparty fails in management positions in large WKHLQWHUYHQLQJWLPHWKHLPSDFWLVOLNHO\WREHVLJQL¿FDQW energy companies and investment and may involve considerable hardship. In contrast, a banks. As an independent number of investment banks are now able to rapidly consultant, he has also advised commodity hedge funds on energy SURFHVV FRQ¿UPDWLRQV (QHUJ\ FRPSDQLHV VKRXOG DLP WR trading opportunities and provided HPXODWH ¿QDQFLDO LQVWLWXWLRQV LQ WKLV UHVSHFW PHDVXULQJ expert opinion in legal disputes. FRQ¿UPDWLRQWLPHVDJDLQVWLQGXVWU\EHQFKPDUNVWRERWK [email protected] LPSURYH HI¿FLHQF\ DQG UHGXFH WKH ULVN RI EHLQJ OHJDOO\ XQDEOH WR HQIRUFH DQ XQFRQ¿UPHG WUDGH LQ WKH HYHQW RI Sunilkumar Ramakrishnan counterparty bankruptcy. a Senior Manager based in London, has more than 12 Invoicing is another area of concern. Delays similar to years of experience in program WKRVHHQFRXQWHUHGLQWKHFRQ¿UPDWLRQSURFHVVFDQRFFXU management, project management, business consulting, and business with complex pricing terms and delivery quality issues analysis within the energy trading often being their root cause. Again, energy businesses and investment banking sectors. would do well to put metrics in place to measure and Previously, Sunil was a Deputy monitor such operational processes as invoice generation. Manager Energy Trading and Risk 7KLVLQWXUQZRXOGDOORZ¿UPVWRLGHQWLI\ZHDNVSRWVDQG Management for a Fortune 500 energy trading company. take appropriate remedial action. [email protected]

CROSSINGS: The Journal of Trading & Risk Management 52 53 %RVWRQ 'HOKL /RV$QJHOHV Singapore 131 Dartmouth Street Towers D & E &ORYHU¿HOG%OYG Level 25 3rd Floor '/)&\EHU*UHHQV Suite 600 South North Tower Boston, MA 02116 DLF City Phase III Santa Monica, CA 90404 2QH5DIÀHV4XD\ USA Sector 25-A USA Singapore 048583 Tel: +1 (617) 621 0200 *XUJDRQ Tel: +1 (310) 264 6900 6,1*$325( Haryana Tel: +65 (6) 622 5813 &DOJDU\ INDIA 1HZ

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