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.
In recent months a growing number of Alternative Trading Venues have appeared, particularly for traders of Corporate Bonds. To an extent this is an inevitable evolution of what has traditionally been a voice brokered market. It is merely following the path laid out by equities over the last 10 years or so. In the field of equities unchecked growth of alternative venues led to instances of platforms paying for prices, providing preferential access to certain customer types, and allowing increasing numbers of complex and potentially abusive order types. We would hope that lessons have been learned from the mistakes of the past. Controllers at Financial Institutions need to examine whether trading on Alternative Trading Venues have been captured by their New Product Approval processes or similar. They need to ask themselves what controls they have in place to prevent traders from influencing valuation processes such as IPV and collateral valuation, and whether contributing prices to these venues could result in a benchmark contribution. Does the accessibility of Alternative Trading Venues provide opportunity for their traders to side step Trade and Transaction Reporting obligations and therefore suppress their trading activity from the wider market place?
http://www.bbc.co.uk/news/business-29406712 The protests in Hong Kong come at a time when Banks and Trading Houses are determining strategies and budgets for the forthcoming year, and bonus discussions move into a final phase. There is therefore a strong incentive for traders to cut exposure to the market to protect their compensation for the year. As houses will likely find themselves making towards the exits at the same time, volatility will increase as liquidity is limited. We expect that Market Risk Managers will pay close attention to house delta, gamma and vega exposure, however, they must ask themselves what line of sight do they have over alterations to the static data underlying the risk reports they compile? Great challenge also resides in the areas of Product Control and Independent Price Verification. If traders find themselves unable to physically reduce exposure, the temptation will exist to adjust static data to give the impression of reduced exposure. Input Volatilities, Credit Spreads, Dividend Yields all represent subjective risk inputs to the model. Reduced liquidity also creates problems for control staff performing price testing. Product Controllers should be asking where does this mark come from? Does the mark reconcile to other instruments within the bank?