What is Modern Risk Management? by CTRM Center

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WHAT IS MODERN RISK MANAGEMENT?

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What is Modern Risk Management?

INTRODUCTION In all of its forms, risk management is rapidly growing in importance within the commodity asset class. It will only become even more critical and complex in the future. Driven by unprecedented levels of change in the industry ranging from geopolitics to carbon, effective risk management is shifting for many commodity firms from just another activity to be managed to a critical component of business strategy that helps drive and inform brand, gain financing and trust, and demonstrates proper controls. Of course, larger commodity-oriented businesses have always had a more sophisticated approach to managing risk, even using it as a strategic and competitive advantage. These businesses are heavily impacted by the number and pace of change in the industry and inhibited by their legacy

solutions and overall systems architecture capabilities. This paper looks at why a new and broader risk management focus is rapidly emerging in commodities, what it involves, and what this means for risk management solutions and systems architectures, particularly at toptier commodity businesses.

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A HISTORICAL PERSPECTIVE Outside of hedging, risk management in commodities developed back in the late 1990s almost as an afterthought in many commodity businesses. It was initially comprised of fairly rudimentary reporting around positions and exposure. Early E/CTRM (Energy/Commodity Trading & Risk Management) vendors paid lip service to this emerging requirement with some rather simplistic risk reports, and it was that that served the ‘RM’ side of the ‘CTRM’ label. However, specialist firms, the more prominent commodity traders, and big banks had a much more sophisticated approach to aspects of risk management, often developing internal models and analytics. While initially, almost all attention to risk involved price or market risk, the collapse of Enron and the energy merchants focused attention also on credit risk. Several commodity-focused credit solutions came to market at that time. However, most commodity trading and related firms continued to rely on rudimentary risk reporting via CTRM or homegrown solutions and spreadsheets. Risk sophistication only gradually emerged, led by firms who saw it as a differentiator and a means to preserve and protect profits. Over the last decade or so, the emphasis on improved and more comprehensive risk management and better, more appropriate analytics has gained traction across the industry. However, this was inhibited by using solutions that did not offer much sophistication in risk management. Specialist risk vendors and vendors serving other asset classes began to emerge in providing better risk coverage. However, in the latter

case, the risk analytics and models were often not tweaked to the specifics of commodities and commodity markets. Again, this usually meant that the emphasis was on home-grown tools, spreadsheets, and niche software solutions. Larger commodity businesses with more emphasis on risk analytics often lacked a top-down, consolidated view of holistic risks and used a variety of stand-alone tools or used differing calculations in different departments in areas such as counterparty credit, market risk, liquidity risk. This might result in discrepancies between those departments and a need to drill into and understand any differences. These firms also often faced an integration nightmare using many different CTRM and related solutions across a business that traded multiple commodities and other asset classes. It was challenging to reconcile differences between them or gain a consistent and timely enterprise-level view of the various or aggregated exposures. A further problem also developed in that many risk analytics were not considered fit for specific use cases requiring the development of complex and specific analytics for such cases, such as gas storage models, PPA agreements, and similar. These types of models were simply not available in standard CTRM solutions nor, indeed, in risk solutions that primarily targeted other asset classes.

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CHANGE DRIVES INCREASED RISK COMPLEXITY In the last few years, change has perhaps been the only consistent aspect of commodity markets. Many of these changes have only highlighted the paucity of effective and holistic risk management and analytics in the industry. That has driven a new focus on risk management and new demand and appetite for more sophisticated and commodity-appropriate risk analytics, software, and services. One of the most significant shifts has been in terms of what stakeholders look for – especially financing banks1. Here, while some banks have left the sector2 altogether, those that remain are actively looking for far more stringent controls and risk management. Their risk and control audits are very detailed and involve people with expertise in the industry. Regulators are also more actively engaged in understanding risk, exposure, and ensuring proper market behavior3. The message being sent is loud and clear – both financiers and regulators expect better controls and risk management. Managing risk in commodities has never been more complex and challenging than it is today. Trade wars, tariffs, and sanctions are all geopolitical risks that can impact everything from demand to sourcing and pricing to profit and thus may suddenly impact credit, market, and liquidity risk. The recent pandemic and resulting work from the home environment have also affected historical demand patterns, disrupted sourcing, and enhanced risks around the security of access to corporate systems. This has driven a move

to more sophisticated risk modeling, stress testing, and analytics that do not rely on historical price data. In many cases, historical trends have broken down. Unexpected events also occur quite frequently, such as the sudden collapse of oil prices last spring or even due to a tanker that blocked the Suez Canal more recently. Increased regulatory oversight has also meant more and increasing compliance issues, the need to demonstrate greater and more effective controls and risk management. Climate is now viewed as the next big challenge, and it will have a massive impact on all commodities - commodity production, trade, and movement. The need to track and report carbon footprints, the move to seek lower-carbon alternatives like the ongoing energy transition, or simply the development of green commodity instruments will increase transaction and compliance complexity and risk management. Climate risk is not merely limited to transactions but also

https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/hit-by-40-revenue-slump-commodity-trade-financefaces-bank-retreat-reshaping-59914072 2 https://www.bloombergquint.com/opinion/why-banks-are-exiting-trade-and-commodity-finance 3 http://www.hfw.com/downloads/HFW-Commodities-Bulletin-February-2015.pdf 1

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counterparty credit, asset insurance, trade finance, and more. With over 60 carbon markets globally, the lack of a single carbon price will only make this even more

complex, but one thing is sure, this may impact every facet of risk analysis going forward.

DIGITALIZATION Although the primary purpose behind digitalization is seen as automation and increasing efficiency, it also has risk implications. Many companies operate with different and heterogeneous solutions for ERP, accounting, treasury, various commodities, etc. Some also use spreadsheets extensively. In such an environment, it is often difficult, if not impossible, to get a good overview of risks due to integration, interfacing, and data sourcing and latency issues. However, as companies digitalize, hopefully, these issues are also being addressed. That is also driving the need for superior risk analytics and reporting solutions capable of aggregating across different commodities and, indeed, other asset classes, like FX and credit. This trend is also potentially driving a move towards deploying an ‘ecosystem’ of open solutions and away from the monolithic do-everything customized software solution that is often sub-optimal and requires off-

system spreadsheets and tools to help manage the business and its processes. Part of this trend is also to consolidate the various risk platforms in areas like market, credit, and treasury for an aggregated, enterprise-wide view of risk. For example, ecosystems can allow specific and discrete deep vertical domain functions or applications to work effectively with broad horizontal solutions like risk analytics and reporting. The move to the cloud, software as a service, open APIs, and new technologies facilitate this migration. Now it is possible to deploy sophisticated risk analytics, reporting, and measurement tools that aggregate risk metrics from across multiple systems to provide a timely enterprise-level risk management layer.

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THE FUTURE OF COMMODITY RISK MANAGEMENT With many significant business and technology drivers in play, risk management in commodities may well be set for an explosion of change in itself. We expect to see, among other trends, • A move to supplement traditional risk management analytics using historical data with more sophisticated modeling and stress testing of portfolios, • A trend to ensuring that the analytics and models used are fit and proper for the commodity asset class and specific physical characteristics of each commodity, along with a need for the flexibility to change and adapt models, • A move to build system architectures that are more amenable to providing an aggregated and holistic view of risk across the enterprise with consistent calculations and reporting across all risks – credit, market, liquidity, and others. Of course, high performance is essential to deliver these functions in near real-time. We also expect to see horizontal risk analytics and reporting layers that aggregate data from many underlying CTRM and other solutions. A microservices containerized architecture is becoming the architecture of choice for these reasons. • Greater emphasis on having tools to help explain and address shifts in measures like PnL, VaR, and so on, which is often complex and requires a capability to drill down into the data,

• More emphasis on counterparty credit risk, mainly as a result of trade finance issues and events like the pandemic, and towards single risk platforms that cater for credit, market, and other forms of risk, • Increased climate-related impact on risk measures that will emerge soon, • The movement towards near-real-time risk calculation and calculations that are event-driven. This latter point is essential as it means updating risk metrics as prices change, deliveries are made, or other events in the supply chain occur that can impact exposures. Risk solutions will need to be capable of rapidly aggregating data from various sources – market data, trade data, counterparty data, and more. This information will need to come from multiple systems across and outside the enterprise requiring integration, aggregation, and data validation. The UI of the solution also needs to be flexible, allowing users to build personalized dashboards and reports – often with a graphical UI – and plugin different models over time. Additionally, it will need to simulate and manage large amounts of data across all types of simulation types. The larger and more complex the commodity-focused

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business, the greater the magnitude of this issue and the need for scalability, speed, and flexibility, perhaps taking advantage of scaling technologies for performance. Given this, it is doubtful that the risk functionality in a CTRM will ever suffice for anything but local risk

measurement. Even if larger firms consolidate the number of CTRM solutions they use, we still expect to see the emergence of advanced commodity risk analytics solutions that overlay underlying transaction management solutions and systems in treasury and elsewhere to provide a top-of-the-house, holistic view of exposures.

FIS’ ENTERPRISE RISK SUITE READIED TO POWER COMMODITY RISK MANAGEMENT One example of such a platform is FIS’s Enterprise Risk Suite, a risk-based pricing, optimization, and control software solution for market and counterparty credit risk. The platform is designed to aggregate data from multiple disparate underlying systems to allow simulation, real-time limit management, and a consolidated and holistic view of risk at the enterprise level and is targeted at top-tier firms. It is also the basis for a risk as a service offering from FIS for smaller commodity firms.

Fig. 1. Modular and scalable architecture

The software is built around a microservices architecture to offer superior performance for calculations that are commodity-specific and complex. This architecture also supports the flexibility to move away from the old monolithic applications while still offering a consistent view of risk across all types of risk. It features high-performance commodity and usagespecific analytics and an ArtiQ in-memory Cube & DataMart for robust aggregation and reporting that it uses for limit monitoring and deal-scenario drill down. The software is configured to be scalable and delivers both the fast performance and ease of use that larger

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commodity firms now need. It also provides a UI that provides for graphical and text-based reporting, and pivot table reporting with flexible dashboards allowing drill-down in a highly usable UI in HTML5 technology. It has the flexibility to enable job management for better performance and results traceability. It has been designed and configured for large-scale and complex environments where data is extracted or aggregated from various sources, validated, and used to perform calculations and report results on a timely basis.

With a proven track record of use with various firms for commodities, FIS also has a reputation backed by many case studies in large commodity firms delivering superior risk analytics and controls in the sector. It covers not just market risk but also credit risk where it offers fast PFE and XVA calculations and features like dynamic dates in PFE calculations to enable efficient use of dates by automatically pointing to the dates relevant for cashflows.

Fig. 2. High performance calculations and modern webbased UI

It also comes with cross-asset capabilities, so not only does it support out-of-the-box valuation models appropriate for specific commodities and deal types, but it also allows the impacts of FX, IR, and Credit derivatives to be assessed and monitored as well for an enterprise-wide holistic view of risk. It supports deal types with physical delivery and for commodities like power and is flexible enough to easily onboard new deal types and models, always a challenge for risk management software designed primarily for the banking space that does provide sophisticated risk models but is incapable of dealing with the granularity of (sub)hourly power deals, for example. API’s allow users to easily include custom models and FIS also allows customers to update and change standard models.

Fig. 3 Flexible integration of third-party models along with own models

The solution is robust in the areas of scenario simulation, and what-if analysis – tools increasingly used as historical trends have broken down and covers a wide range of specific commodity specifics out of the box, such as for energy, • Physical energy deals (Sub daily granularity, delivery, and pricing profile. Fixed and floating prices, daily, (sub) hourly fixing. Formula pricing, index pricing. Different fixing methods) and valuation methods like Forward prices with flexible sub daily profiles. NPV of cashflows,

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• Energy options (Simple and basket options of physical energy trades. Style: European, Asian) and valuation methods like Black, Black & Scholes, Hull moment-matching, • Transport contracts (An hourly option with two underlying physical legs: one positive and one negative for the entry- and exit- point commodities. The strike corresponds to transport costs.), • Forward Curves (Constructed from forward contacts, includes profiles. Profile definition is sub daily, flexible. Price can be independent (imported) or derived) and valuation methods like One-factor and multi-factor (based on PCA) mean-reverting process with term structure of volatility and of reversion speed, Stochastic volatility models, etc., • Formula Prices (Linear combinations, min, max functions, typical gas price formulas supported). FIS also provides cloud and application managed services offered for the FIS private cloud and public cloud as well as additional services like quant or market data services along with the solution. Being a major player in the financial services industry, FIS provides very high standards of security. It also provides its security layer upon the public cloud to provide its customers better protection against hacker attacks on cloud-based applications. The FIS Enterprise risk suite has already been adopted by many top-tier energy and commodity firms. These firms often shared similar characteristics such as, • Aging legacy risk solutions that were slow, unable

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to adapt to changes, and couldn’t truly handle the needs of a sizable, multi-commodity business that also engage in trading other asset classes like interest rates, debt, FX, and so on, Legacy solutions that could not handle the amounts and complexity of risk-related data, A heterogeneous legacy systems environment incorporating multiple CTRM solutions, treasury systems, and other software leading to difficulties in obtaining a holistic view of risk across the enterprise, An inability to use more sophisticated risk analytics like for example, PFE for credit or more commodityfocused valuation, The high cost of maintaining all the solutions used and the integration/interfacing between them, Being limited in their ability to apply a comprehensive set of risk measures and controls such as risk limits, for example, due to the nature of their risk systems and overall systems architecture.

By adopting the FIS Enterprise risk platform, these businesses overcame many of these challenges, reducing costs, implementing their risk and control policy, and having more timely and valuable risk analytics and measures in place. As we have seen increasingly, managing risks (market, credit, liquidity, etc.) and demonstrating controls are seen as a must by stakeholders and management. With the increased impact of climate and carbon measures, this will only become more acute.

SPONSORED BY FIS FIS is a leading provider of technology solutions for merchants, banks and capital markets firms globally. Our employees are dedicated to advancing the way the world pays, banks and invests by applying our scale, deep expertise and data-driven insights. We help our clients use technology in innovative ways to solve business-critical challenges and deliver superior experiences for their customers. Headquartered in Jacksonville, Florida, FIS is a Fortune 500® company and is a member of Standard & Poor’s 500® Index.

To learn more, visit www.fisglobal.com. Follow FIS on Facebook, LinkedIn and Twitter (@FISGlobal)

ABOUT Commodity Technology Advisory LLC Commodity Technology Advisory is the leading analyst organization covering the ETRM and CTRM markets. We provide the invaluable insights into the issues and trends affecting the users and providers of the technologies that are crucial for success in the constantly evolving global commodities markets. Patrick Reames and Gary Vasey head our team, whose combined 60-plus years in the energy and commodities markets, provides depth of understanding of the market and its issues that is unmatched and unrivaled by any analyst group. For more information, please visit:

www.comtechadvisory.com ComTech Advisory also hosts the CTRMCenter, your online portal with news and views about commodity markets and technology as well as a comprehensive online directory of software and services providers. Please visit the CTRMCenter at:

www.ctrmcenter.com

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What is Modern Risk Management?

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WHAT IS MODERN RISK MANAGEMENT?