In recent years Control Staff have found their workload dominated by rooting out bad behaviour resulting from poor culture. The beginning of 2017 heralds a decade since the onset of the Credit Crisis, which set the stage for a fundamental repositioning on how Financial Institutions and their staff conduct business. All the while however, the markets have been in a prolonged cycle of status quo. Households and businesses have enjoyed prolonged low interest rates, and Central Banks have been preoccupied for the most part by the threat of falling prices. This cycle looks set to change.
The Federal Reserve has signalled that rates in the world’s largest economy will appreciate. The United Kingdom and Europe continue to work on how to decouple their longstanding relationship, weakening Sterling, and importing inflation into the UK economy. Traders, in Fixed Income at least, are finding out that volatility is no longer a distant memory.
As the mighty Yield Curve begins to move, forward and inflation curves are reassessed. It is during moves such as these that system driven errors begin to be uncovered. Incorrect curve mapping, stale static data and the assumption of product behaviour are examples of risk unmasked by market change. Control Staff could well find 2017 their most challenging year yet, as work remains to be done improving and monitoring staff behaviour, but market change will test many of the controls perceived to be robust. As staff within Internal Audit, Compliance Monitoring, Product Control and Risk Management plan for the year ahead, we advise them to carefully cast their eyes towards reviewing systems, static data and product mapping, lest the winds of change whip up a storm.
As the dust settles from thursday’s shock move by the Swiss National bank, news is beginning to emerge of the impact the Franc’s appreciation has had. As Product Controllers and Market Risk Managers get to grips with traders’ exposures, and whether internal risk limits and stress tests have proved adequate, they would do well to consider wider areas of exposure. We take this opportunity to highlight potential areas of risk which warrant consideration. We have been warning that FX along with Funding represent two areas where scope remains for traders to take significant risk in their trading books. Owing to the pooled nature of currency booking which still exists at many Financial Institutions, and the fact that FX booking systems often stand alone from the primary booking engine for many businesses there is wide scope for error and abuse. We recommend Control Staff turn their attention to verifying that derivative structures have been booked correctly. Quantos booked as Composites and vice versa represent a significant area of risk. Rehedging within Legacy Businesses is a cause for concern as staff with responsibility for managing portfolio wind downs may not be aware of the need for currency rehedging through the life cycle of structures – last week’s move will make this apparent. Counterparty credit will be recognised since a number of brokerages have already failed, however staff must now consider the impact on derivative contracts which had seemingly benign payoffs, as well as the exposure of Mortgage customers who have been sold out of currency products offering yield advantage though Swiss Franc borrowing. Legal and Compliance as a priority should review how these products were solicited, marketed along side the supporting documentation.
On Monday, the Russian Central Bank took bold action, raising interest rates by the most in 16 years. Elsewhere around the Emerging Markets risk premia rose, with a knock on effect to volatility. Interest Rate rises of this kind were witnessed in 1997 and 1998 when Central Banks’ sole objectives were stabilising currencies. What gives us grave concern is that Trader Funding Risk remains, in our eyes, a risk for many banks.
Historically Financial Controllers were responsible for ensuring adequate funding was in place to support traders’ market positions. The responsibility for Cash Management, to give Trader Funding Risk another name, has gradually been handed over to the people trading the underlying assets. Positions resulting from structured trading generally have specific term structures. Funding Risk related to these activities is relatively transparent. Market-making positions and certain proprietary strategies have less certain holding periods and therefore the funding required to support them is of varying term.
Within banks there appears to be little line of sight over the specific Funding Risk traders take. At the macro level Treasury Departments can generally see whether a business is funded, they may be able to see the term, but they cannot relate that to the Market Risk the traders are running and whether it is appropriate. This is because Market Risk is the remit of Market Risk Management. Market Risk limits are generally transparent and well understood. The expectation is that Funding Risk traders take will relate directly to the Market Risk they are running. The assumption is that a limit structure for controlling Funding Risk would be unnecessary. Trader Funding Risk therefore is in danger of falling between the two controls.
A further layer of complexity is added by those businesses able to generate their own funding, either through synthetic trading or certain lending activities. Funding Risk generated in this way can be reflected in the Market Risk Report or the Business’ Funding Report depending on how the positions are booked out. This makes Funding Risk opaque, and indeed this may suit certain traders, particularly those that opt for internal arbitrage strategies, ie generating profits from their own bank’s weak accounting and control. The fact that some traders continue to exploit banks’ internal systems for their own benefit, rather than highlight failings to control functions, reflects the challenge facing banks that are attempting deep cultural change.
Juniorisation of trading teams since the 2008 crisis adds to the risk facing banks. Traders are now used to a long stable low interest rate environment. Traders who began trading in 2009 now have 5 years of experience under their belt, and will likely have significant confidence and trading limits. They have only traded in one interest rate environment and there is a risk that they are unaware of the potential pain sharp rises may cause.
Finally the move in interest rates heightens the risk of trader malfeasance, as traders facing losses in late December will face the temptation of hiding losses to protect bonus payments. With Funding Risk lying outside of the main booking system for many businesses there is double key entry risk, with trades not being booked in both systems, as well as place holder risk i.e. Traders manufacture positions through placeholders relying on large orphan cross bank positions to muddle the control functions.
Hopefully our concerns will not play out, but it would be prudent for Audit Managers to raise awareness within their teams.
http://www.bloomberg.com/news/2014-10-01/has-dollar-strength-only-just-begun-.html The continued strength of the US$ has caught the headlines. The charts of Brazilian Real, Korean Won and Singapore Dollar confirm that the move is universal. Continued weakness in world currencies raises the risk of rate increases to protect their trading level with the dollar. Auditors should review cash management processes as part of their continuous assessment of businesses. They must ask themselves what line of sight do control functions such as Treasury and Market Risk Management have over funding versus assets? Can these areas distinguish between duration of funding positions or are traders exposing the firm to short term funding risk? During the Asian Crisis of 1997 equity derivative businesses which funded using overnight rates learned the hard way about how fast Central Banks move to defend their currencies. Juniorisation of trading staff since the recent Credit Crisis mean that few will remember the lessons of the Asian Crisis.