RISK REVIEW
WHERE IS THE GLOBAL INDUSTRY TODAY?
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CONTENTS Welcome to the Risk Review
Page 2
Regulation | Basel IV – The unbearable standard
Page 4
Market Risk | Five icebergs in the investment floe
Page 8
Credit Risk | What is the true cost of Sovereign default?
Page 12
Operational Risk | Quo Vadis Operational Risk? Emerging Page 14
operational risk management techniques
Modelling | Top 5 Innovations in Modelling
Page 16
Innovation & Disruption | Four long-term impacts of DLT Page 18
and Blockchain
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SPECIAL THANKS & CREDITS Editor: Sophie Cater, Digital Content Manager, RiskMinds Contributors: Barbara Mack, Journalist, Dan Barnes, Journalist, Massimo Morini, Head of Interest Rate and Credit Models at Banca IMI, David Carruthers, Head of Research at Credit Benchmark, Lisa Riordan, Head of Operational Risk in Deutsche Pfandbriefbank AG, Dr. Klaus BĂścker, Head Risk Models & Analytics at Deutsche Pfandbriefbank Contact: sophie.cater@knect365.com
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WELCOME TO RISK REVIEW Where is the global industry today? As we move towards
risk managers as well as the
December’s RiskMinds
micro details of credit risk,
International conference
operational risk and modelling.
and the final part of the year there is a strong feeling
RiskMinds International brings
of anticipation in the air.
together the very best experts
The American election
in their fields to address the
looms in November; the
strategic and the technical
“Basel IV” requirements are
risk challenges facing the
within touching distance;
industry today and in the near
and innovation is shifting
future. It is our hope that this
increasingly into main
magazine will provide you with
stream thinking.
some timely, engaging food for thought between now and the
This edition of Risk Review
conference in Amsterdam this
delves into the crucial macro
December 5-9.
factors on the horizon for
ED STAPLEY EDITOR-IN-CHIEF, RISKMINDS 3
Join a panel of industry experts to discuss “Basel IV” - What It Means For Banks And For The Economy at RiskMinds International on 5th December.
Basel IV, as last year’s proposed amends to Basel III are dubbed, is
REGULATION
unworkable for banks in Canada, Europe and Japan. That is the conclusion of many practitioners who
BASEL IV – THE UNBEARABLE STANDARD
The move to standardise approaches to capital requirements under ‘Basel IV’ are a blunt weapon, say bankers. BY DAN BARNES
are seriously concerned about the rewriting of capital requirements, set under the Basel III regulation. The changes to Basel III, announced in the summer of 2015, are intended by regulators to create a standardised approach to the way banks measure their capital requirements. Iain Mackay, group financial director at HSBC, told analysts on 6 May 2016 that adding up the capital required of HSBC and all of its competitors would not cover “a small fraction” of what was needed given the potential impact of standardised internal risk based approach (IRBA), operational risk and market risk. “I think we’re all pretty much stuffed,” he said, if there were no change to the proposed rules. “On that, I’d add that if we’re all stuffed, then we’re less stuffed than everybody else, because we generate capital and we have multiple means by which we can manage capital to overcome the obstacles.” Marcus Schenck, chief financial officer at Deutsche Bank concurred in a call with analysts on 26 July 2016 when he said, “It looks like the impact [of Basel
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IV] is humongously draconian and
would essentially be a complete game
a standardised floor on it you have
“The US haven’t really implemented
changer for the banking industry on
exactly the same problem.”
things like the IRB, they are using
this planet.”
Patricia Jackson, partner and special
a different method which is CCAR,
adviser on Risk Governance for EMEIA
a stress testing approach,” says
Pinpointing the exact level of
Financial Services at consultancy EY
Jackson. “That is really based around
increased capital required is hard;
says, “People have forgotten about
the Fed’s own IRB models. So I think
consultancy EY cite an increase of 40%
the distortions caused by Basel I
geographically people have gone down
made by the Basel Committee, while
and they are just focussing on more
different routes. It’s not just in Europe,
the European Banking Federation
standardisation across countries.
it’s in Japan as well. It’s countries
put the figure at €600-900 billion at a
If you standardise at 2% capital
which have implemented the IRB
journalist briefing in August.
requirement that’s not standardising
but which have large, high-quality
it relative to the risk, if one bank has
corporates still borrowing from the
One sizes fits few
an ‘A’ quality book and another has
banks and that’s just a fact of life in
Basel IV changes several of the
a ‘BB’ quality book. So it looks like
markets outside the US.”
existing measures imposed under
standardisation but it’s a wholly un-
Basel III in order to present a
level playing field.”
standardised approach to the way banks assess capital requirements.
One source said the BIS might revise the level of advanced IRB for corporate
While Basel III is seen as a necessary
mid-cap lending to €500 million of
and important step change in the
consolidated turnover, with foundation
“The removal of internal modelling for
quantity and quality of capital being
IRB increased for the largest
wholesale exposures and specialised
held, it originally went with the grain
corporates and for specialised lending.
lending, removal of internal modelling
of the risk-adjusted capital measures
However even with these reforms,
for credit conversion factors (CCFs)
that were already in place. Where
issues would still exist with the lack of
and the CCF calibration proposed in
it was requiring much more capital,
recognition of bank risk management
the standardised framework and then
it was on a risk adjusted basis. The
practices and the capital framework, in
the floors are our members’ main
risk from proposed changes to the
the IRB framework.
issues,” says Jacqueline Mills,
internal ratings based (IRB) approach
director for Prudential Regulation at
is that the regulators are going back
Jackson says, “Some of the proposals
the Association of Financial Markets
on all of those risk adjustments.
have to be re-thought and I think that’s
in Europe (AFME).
At a practical level, requiring an
quite likely to happen with the IRB,
additional two percentage points
because the effects are so great.”
In some ways the pressure to
of capital for lending to a large
Recent media reports have suggested
standardise the approach to risk
corporate can make the process
the European Commission will take
versus capital represents a step
uneconomical, damaging the lending
a strong line to defend its banks and,
back in the approach to risk. Under
channel and given the scale of the
given the strength of feeling amongst
Basel I requirements drew very little
effect, potentially the economy.
the firms themselves it seems clear
lending. The Basel committee
Enter the draconian
be needed.
engaged in a considerable review
Understanding the potential for
of the effect that Basel I was having
reforms of these proposals will
Mills says, “We are not sure what these
before developing Basel II, and found
depend on who and how concerned
very strong positions will now mean
it was causing enormous distortions
people are about the existing
for negotiations.”
including in the United States.
approach. The imbalance EY’s
The effect of floors only adds to
Jackson observes is perhaps most
the problems by forcing minimum
notable across geographies. In the US
levels of capital on the industry.
capital markets have long been used
distinction in quality of corporate
either reform or compromise will
by corporates seeking to raise funds. Mills says, “Floors compound the
In Europe and Japan where bank
loss of risk sensitivity and even if
lending is still a major source
you improve the risk sensitivity in
for corporates to raise funds, the
the RWA framework and then stick
current regime is more punitive.
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5 - 9 December 2016 Hotel Okura, Amsterdam
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MARKET RISK
For many market observers China has been the biggest macro story; it has had a significant impact upon other
FIVE ICEBERGS IN THE INVESTMENT FLOE
emerging markets and its market
The risk landscape for many firms will be determined by several macro factors; these are top of the list.
of a similar magnitude, changing the
reforms are changing the investment landscape, from currency to equities to bonds. However, other macro issues are also shaking up the investment picture and could have repercussions economic picture and thus hitting markets. Here are the top five macro risks that analysts see looking forward. Political risk Populism is not limited to any one country. There are many movements
BY DAN BARNES
in many countries that reflect a lack of faith in existing political doctrine, parties and their policies. The British referendum to leave the European Union (Brexit) is a case in point, however various other referenda from the Colombia FARC peace deal to
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Hungary’s rejection of European Union
threaten to overturn long-standing
oil importers so the fall in prices has
(EU) migration quotas are good points
political directions make this
brought down inflation and boosted
of comparison. The effect on markets
characterisation relatively widespread.
purchasing power.”
short term, whilst in the longer term
Oil
Nevertheless, timing seems to have
economic growth can be affected.
The cost of oil has wide-reaching
led many of those economies to be
effects from the economic impact on
hard hit, whereas the benefits are
Writing on Clinton and Trump for the
oil producing countries to the cost of
likely to take longer to feed through.
US election coming up, Kevin Logan,
industry in other markets. It is also one
chief US economist at HSBC Securities
of the most opaque markets for price
says, “Clinton is the standard bearer for
setting. Consequently, it is both hard to
the status quo and her proposals tend
predict and its effects are wide ranging.
is typically one of volatility in the
to be micro – relatively small-scale changes in numerous programs that
“A few countries that are very
can bring targeted benefits to various
dependent on oil exports that have
constituencies. In contrast, Trump is
suffered quite heavily [from the fall
the candidate of change. He advocates
this year], now the big extent to which
an extensive revamping of trade,
they suffered depends on the buffers
immigration, and tax policies. His
they built during the period of high
approach is more macro – large-scale
oil prices,” says William Jackson,
changes that would overhaul policies.”
senior emerging markets economist
Discover the key market risks at RiskMinds International on 7th December. CLICK HERE for more.
from Capital Economics. “Most Across countries the use of referenda
emerging markets should benefit
and the rise of candidates who
from low oil prices because they are
9
“We have probably seen the worse
While they are facilitating debt
direct effect on investors. There is the
happen for most of the major oil
issuance in the primary market, with
potential for a bank to collapse if risk
producers, Russia’s economy seems
corporates in particular keen to take
is not properly managed as revenues
to be recovering, albeit slowly,” says
advantage of the low interest rate
continue to fall, and governments are
Jackson. “We get the sense that
environment, their ability to make
still on the hook for bailing them out.
positions of the Gulf States have
prices and take risk in the secondary
improved a bit, although there a
markets is severely reduced. In its
Central banks
few countries such as Nigeria
report ‘Capital Markets and Investment
Quantitative easing (QE) programmes
which have had a bit of a botched
Banking 2016: Time for Tough Choices
and low-to-negative interest rates
response to low oil prices and are
and Bold Actions’, consultancy
have become a cul-de-sac for central
still in recession.”
McKinsey & Co found that return on
banks, while they have aimed to
equity was flat last year at 10%, while
stimulate growth. Their acquisition of
Investment banks
European investment banks were even
government and even corporate bonds
The challenge facing investment
lower at 5%.
has hit investors; Bernstein Research found that traded volume in European
banks primarily stems from their capacity to support that levels of
With big banks pulling out of major
government bonds is down around
capital they need. Restrictions
business areas, for example Credit
12% as a result of the European Central
placed upon activity and stringent
Suisse’s withdrawal from the
Bank taking out around 8% of the
capital requirements are both
secondary European government bond
available pool of European government
a consequence of regulation.
market and JP Morgan’s withdrawal
bonds. It predicted in March that
The upshot of these rules is that
of many prime brokerage services,
corporate bonds would see a reduction
the major banks are removing
activity in the markets is reducing.
of 15-30% of the liquidity for taking out
themselves, or being removed,
The higher price of liquidity in credit
6-12% of stock. The acquisition of these
from activity of certain kinds.
markets is one clear example of a
instruments also distorts bond prices.
Global CMIB industry post-tax ROE1 analysis, based on nationality of bans
0 TOP 10
EMEA
11 144
12
10
-5
35
16
-9 -5
46
13
APAC
Tier 1 capital ratio3
-3
7
Americas
Global CMIB
Revenues / RWA
Revenues2 US$ billion
ROERWA1
-4
58
-6
282
-5
10.5
Cost income ratio4 17.4
58
12.4
13.2
100 76
53
11.8
52
12
49
12.4
min max
64
Return on Tier 1 equity (ROERMA), assuming tax rate of 30% Includes both core and non-core divisions (i.e. bad banks) for Bank of America/Merrill Lynch, Barclays, BNP Paribas, Citicorp, Deutsche Bank, Goldman Saches, JP Morgan, Morgan Stanley, UBS 3 Group level ratio 4 Includes operating expenses, litigation and restructuring expenses, one-offs, as well as costs in bad banks 1
2
Source: McKinsey CMIB Revenue Pools; McKinsey analysis; Coalition data
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A paper by economist Ros Altmann
Negative rates are also a having
ranges of assets, some highly illiquid
published on 13 September 2016 found
serious consequences for the
such as infrastructure projects, others
that in the UK low rates were not
portfolio managers at pension and
more risky such as emerging markets
reflected in the retail market, with the
insurance companies who are less
investments. In 2008 economists woke
average standard variable rate mortgage
able to cover their risk exposures
up to the importance of the finance
higher in 2016 than in 2011 while savers’
with debt instruments. Consequently,
sector to the economy; ignoring it now
interest rates have fallen sharply.
investment is moving into wider
could be disastrous. Emerging markets and China
Many borrowing interest rates have risen, not fallen Date
Credit Card %
Overdraft Rate %
Standard Variable Rate Mortgage %
2-year fixed Mortgage 75 % LTV %
Aug 2011
16.73
19.38
4.11
2.69
Aug 2012
17.26
19.53
4.27
3.54
China, as by far the largest emerging market, has a sizeable knock-on impact on the rest of the emerging world. The channels through which that risk moves are important in assessing the economic impact. Slower growth in China effects China itself which is home to approximately 20% of the world’s population and is
Aug 2013
17.87
19.54
4.36
2.8
Aug 2014
17.39
19.67
4.52
2.74
Aug 2015
17.91
19.67
4.48
1.72
Aug 2016
17.96
19.68
4.33
1.52
Interest rate change over past 5 years
+1.23
+0.3%
+0.22%
-1.17%
the world’s second largest economy. It then impacts on countries which trade heavily with it such as those in East Asia and then countries which may be affected indirectly via commodity prices. “Large parts of Africa and Latin America might be affected by restructuring China if the prices of the commodity that they export
Source: Bank of England
are affected,” says Jackson. “Other emerging market countries face somewhat different risks, for example
Savers’ interest rates have fallen sharply Date
Cash ISA
1 yr fixed ISA
2 yr fixed Deposit rates
Aug 2011
2.37
2.54
3.08
Aug 2012
2.52
2.53
3.08
Aug 2013
1.26
1.74
1.93
Aug 2014
1.09
1.5
1.52
in parts of Eastern Europe what happens in the Euro Zone is absolutely key, for Mexico it’s the US.” Circling back to politics, there are clearly big risks for emerging markets that are potentially more volatile than developed markets. In Turkey and Russia political risk has been a key issue for investors, and more recently it has been for the Philippines too. With armed conflict making
Aug 2015
1.01
1.51
1.55
the Middle East highly unstable, the risks are enormous for commodity
Aug 2016
0.6
0.94
1.02
Interest rate change over past 5 years
-1.77%
-1.6%
-2.06%
consumers as well as suppliers.
Source: Bank of England
11
Credit Risk
WHAT IS THE TRUE COST OF SOVEREIGN DEFAULT? BY DAVID CARRUTHERS, HEAD OF RESEARCH AT CREDIT BENCHMARK
In the world of credit risk,
observable and frequently update.
sovereign governments are the
But they are distorted by a significant,
most controversial and political
time varying risk premium, although
of all the borrower types. Unlike
this can be quantified if the analyst
a corporate, a defaulting sovereign
can estimate the underlying, ‘real
can devalue their debt or simply
world’ probability of default (“PD”).
refuse to repay. In response, they
There is no shortage of credit risk
may be temporarily locked out of
models, so the challenge is to select
global debt markets; but this phase
one set of comparable PD estimates.
rarely lasts.
The Credit Benchmark approach is to publish crowd-sourced average
The true cost of sovereign default is
estimates across multiple models,
often seen as being more insidious:
calibrated by teams of experts in
years of subsequent under-investment
IRB banks.
and difficult borrowing terms. It can
Join David Carruthers at RiskMinds International on 7th December at 15:30 to hear him speak about Estimating Liquidity Risk Premiums from CrowdSourced Credit Data. CLICK HERE to find out more.
estimates and S&P long term ratings, on the same named obligors.This risk
be difficult to avoid the vicious circle
Figure 1 shows the relationship
premium varies over time, so market-
where one default makes another
between these crowd-sourced
implied ratings need to be adjusted for
more likely. Agency credit ratings are the natural starting point for assessing sovereign risk. But agencies often disagree and the “issuer pays” business model means that they can face some very difficult political and commercial decisions. For the same reason, unsolicited ratings are often met with analyst scepticism. There are at least 50 Sovereign states who are unrated by the main rating agencies. Market implied measures (bond yields and credit default swap spreads) are popular because they are readily
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FIGURE 1
the current level of this risk premium.
This dataset covers a very large
Another advantage of this data set
Credit Benchmark crowd sourced
universe of unrated obligors. Where
is the extension of credit views to
estimates are based on contributions
at least 3 banks have contributed
additional obligors. If two countries share
from at least 3 banks, and are available
estimates, a Credit Benchmark
similar macro-economic and political
for about 90 of the 193 sovereigns
Consensus (“CBC”) credit category
characteristics, and only one is quorate,
recognised by the United Nations. A
can be published as a benchmark
then that quorate estimate can be used
further 53 estimates are contributed
for ratings. The non-quorate names
as a proxy (with a suitable confidence
by 1 or 2 banks.
can be grouped into very granular
interval) for the non-quorate country.
portfolio baskets, providing a rich set There are a number of advantages to
of benchmarks for bank loan books.
this dataset: • Monthly updates
With trends updated monthly, this
• Trends and turning points
data set can also provide early warning
• Confidence ranges for estimates
of potential credit risk changes.
• Model validation for single names
This can, on occasion, include early
• Calibration for PD models
warning of rating agency upgrades
• Aggregates and Indices
and downgrades as well.
About David Carruthers
David is responsible for researching and developing the
FIGURE 2
Credit Benchmark dataset. He previously held roles at Markit Securities Finance, including most recently as Managing Director, and as Head of Quant Research at Data Explorers. Prior to this he held senior roles at risk consultants Barrie & Hibbert (now part of Moody’s) where he was responsible for fixed income and equity portfolio risk analysis, and in portfolio management with Pimco and Murray Johnstone. David holds a PhD in Econometrics from Glasgow University and is a member of the CFA Institute.
13
OPERATIONAL RISK
QUO VADIS OPERATIONAL RISK?
Emerging operational risk management techniques BY LISA RIORDAN, HEAD OF OPERATIONAL RISK IN DEUTSCHE PFANDBRIEFBANK AG, AND DR. KLAUS BÖCKER, HEAD RISK MODELS & ANALYTICS AT DEUTSCHE PFANDBRIEFBANK
A brief history of measuring
banks typically concentrated on the so-
the current debate regarding
OpRisk and AMA
called loss distribution approach (LDA).
the benefits of operational risk
Within the realm of financial risk
The underlying idea of the LDA was
measurement is long overdue. The
management, operational risk
not new, as the insurance industry had
idea to implement a single-number
measurement as a discipline on its own
been using a similar approach which
metric for operational risk, a Value-
is relatively new. The first consultative
had been originally developed by Filip
at-Risk (VaR) at a high confidence
papers, regarding the revised capital
Lundberg in 1903 to quantify the risk of
level which would be comparable and
Basel II published by the Basel
insurance claims.
acceptable as market risk standards,
Committee 15 years ago, recommended
was doubtful from the offset.
that operational risk should be
Since then, LDA type models have been
considered a new risk category in
further developed and specialised to
The main purpose of the AMA
addition to market and credit risk
overcome fundamental challenges such
approach was to technically align the
within the Pillar I framework.
as heavy-tailed loss sizes, in the hope to
operational risk charge with the other
better measure operational risks.
existing Pillar I risk capital charges.
This change triggered the rise
This approach was necessary to
of quantitative operational risk
However, despite the amount of time
fulfill the requirement that all Pillar 1
measurement, as banks were now
and effort invested by both practitioners
risks should be measured under the
allowed, and were additionally
and academics into LDA modelling,
same units in order to make the risks
motivated by the prospect of capital
internal-model based operational risk
comparable. As a result, banks were
relief, to develop their own operational
could not conclusively convince the
required to capitalise against rare but
risk measurement model. Risk
regulators that the model developed
extreme operational risk events e.g.
Management departments started to
could accurately reflect the risk
once in 1000 years.
hire operational risk quants for their
exposure to operational risk.
operational risk departments, software vendors offered tailored solutions,
As a result, in March 2016 the Basel
special operational-risk focused
committee announced that all existing
consultancies emerged and last but
regulatory approaches to operational
not least, external data consortiums
risk would be replaced by a new
gathered loss data in the hope to
standard measurement approach (SMA)
overcome one of the largest hurdle for
which for regulatory purposes makes
operational risk measurement, namely
the internal operational risk models
lack of data.
superfluous.
Although the Basel Committee did not
AMA modelling – Failure by design
provide specific details regarding the
In the author’s view, the digression
advanced measurement approach,
from AMA comes as no surprise, and
14
Dr. Klaus Böcker will be speaking at RiskMinds International on 8th December at 12pm about Operational Risk – Intuitive Vs. Rational/Analytical Approaches. CLICK HERE to find out more.
However, this approach overlooked
About the authors
some crucial characteristics of
Over emphasising the usefulness
operational risk data e.g. it is
of historic data may lead us into a
particularly heavy-tailed and that
false sense of security as historic
Lisa Riordan is Head of Operational
the pattern changes with time. This,
data only provides us with events
Risk in Deutsche Pfandbriefbank
combined with the limited availability
which have already been observed.
AG where she is responsible for the
of internal data, complicated with
Operational risk is concerned with
development and implementation
the already difficult task of model
both known and possible unknown
of Operational Risk processes and
calibration, makes the estimation of
risks. Loss distribution models cannot
governance. She is an experienced
reliable results difficult. As a result, the
be expected to reflect the future risk
conference speaker and her recent
opinion of many regulators is now that
when only using historic data, as the
effort has been on the bank-wide
model results are not reliable enough
collection lags behind the reality of
implementation of frameworks
to be used successfully to compare
the speed of ongoing changes in the
supporting SREP requirements.
capital requirements across the
environment of the banking industry.
Prior to Deutsche Pfandbriefbank she worked in Credit Suisse for 8
industry and therefore there should be no surprise at the request to remove
Both authors have experience in risk
years where her main focus was on
AMA for operational risk.
quantification and management
business process reengineering.
of operational risk, and under no Where to go from here?
account intend to discredit the
But what does this mean for
quantification of operational risk and
the future of operational risk?
promote the management simply by intuition alone. However, we would
It is generally accepted that the
hope that the debate would result in
advanced measurement approach
the opportunity for banks to further
was not just about a method for
develop management of operational
Dr. Klaus Böcker is responsible
quantification, but also resulted
risk, while focusing on the essence of
for market risk and operational
in an improvement in the overall
the risk disciple.
risk methods, counterparty credit risk and XVA calculations at
management of operational risk such as the development and
Eventually, we would hope that any
Deutsche Pfandbriefbank AG.
implementation of structured
new approach would encourage the
He is conducting research in
qualitative frameworks. This
unification of both the management
various fields of finance where
encouraged an enhancement in
and measurement of operational risk
he has authored and co-authored
the maturity of operational risk
where they become complimentary
several articles that have been
within the banking industry, which
rather than opponents, even if the
published in recognized finance
was necessary and valuable in the
benefit may only be seen in the
and mathematical journals. In
development of the risk disciple.
internal management of operational
2007, 2008 and 2010 he won the
However, these benefits do not
risk rather than the regulatory figure.
prestigious PRMIA Institute’s
create a strong enough argument
Award for New Frontiers in Risk
to have AMA in its current state.
Management. Klaus is editor of the two-volume book “Rethinking
Currently AMA seems to promote
Risk Measurement” (2010) and on
the belief that mathematical and
the editorial board of the Journal
loss–data driven simulation
of Risk Management in Financial
techniques are superior in
Institutions.
comparison to the “softer” management approaches which include expert opinion. In fact, many banks have strived to improve their AMA estimates at the expense of developing the scenario-based approaches.
15
MODELLING
Since the late 1800s, technology has served as an essential driver
TOP 5 INNOVATIONS IN MODELLING
of innovation, internationalization, and modernization in the financial sector. The very early days of intercontinental trading were spurred on by the advent of the transatlantic cable system. In fact, the term “cable” came to mean the GBP/USD currency pair rate – a foreign exchange term of art that endures today. After moderate development through the early 20th century, technology started to take off in the post war era; by the
BY BARBARA MACK
1980s, SWIFT communications, DOT systems, and electronic exchanges were at the heart of the market side. And there was explosive growth in credit cards, ATM machines, and mutual funds on the retail side. As the Internet took form and online trading, banking, and financial communications technologies spread across the entire sector, from enormous asset managers to the smallest hedge funds, there have been waves of creation and disruption in FinTech. One steady mantra has been disintermediation; disaggregation is another. But for all the activity aimed at being faster, cheaper, better, there has not been a consistent move towards with centralization or decentralization. Exchanges have consolidated and broken up, as have numerous large firms, some rendered by the not-so-invisible hands of regulators. In the wake of this turbulence (and exacerbated by the financial crisis), there has been a sustained push towards the next era of financial technology – with much of it centred on start-ups. So what exactly are these brash young firms doing? What kinds of innovation are underway and how will this all play out over time?
16
Here are some of the main areas
a crowd-sourcing model to pull capital
of activity in reshaping business
together for start-ups and new ideas.
models and pushing the boundaries of finance today.
Credit Ratings and Fraud Prevention
Payment Systems No matter what is
Drawing on advances in machine learning and
going on in the broader
big data, new products in analytics
economic environment,
and forecasting can help consumers
there is always demand
track their own spending habits and
for technology that can streamline
banking and lending institutions make
payment processes. Early examples
better decisions on creditworthiness,
include PayPal and, more recently
behavioural patterns, and more.
Square, but there are many other names emerging in the FinTech space
Virtual Currencies
these days. Some will be flashes in the
Much has been written
pan and others may truly change the
about bitcoin mining,
way that transactions are processed
from the promise of
and validated around the world.
digital currencies to the perils of a decentralized, somewhat shadowy
Wealth Management
world (e.g. the Silk Road saga).
Retail customers
However, the Blockchain technology
have greater access to
underlying the bitcoin phenomenon
information and portfolio
has the potential to reach far beyond
monitoring tools than ever before.
the digital mines and deep into the
The keen interest in lowering fees
daily transaction, contracting, and
and increasing self-sufficiency have
clearing processes of the world’s
opened up the market for automated
largest financial entities.
wealth management platforms. Sometimes called robo-advisors, the
“In my end is my beginning,” wrote
product offerings come in many stripes
T. S. Eliot in the Four Quartets. The
and sizes. Although they may not
eloquent banker-turned-poet might
displace human advisers in the near
well appreciate that on the heels
term, they can augment the effort to
of a global financial crises, many
understand what is happening in one’s
phoenixes are rising.
portfolio and in the market as a whole. Funding Platforms One of the more recent areas of innovation entails the rise of
Join the RiskMinds International modelling summit on Wednesday 7th December.
online platforms that help small businesses, entrepreneurs, non-profit
CLICK HERE
organizations, and even special private projects to gain access to capital. Some funding platforms focus on debt
BARBARA MACK
to uncover the line-up
and rely on credit markets or crowdfunding to raise money. Others focus purely on equity offerings, again using
17
OIL PRICE
FOUR LONG-TERM IMPACTS OF DLT AND BLOCKCHAIN BY BY MASSIMO MORINI, HEAD OF INTEREST RATE AND CREDIT MODELS AT BANCA IMI
CLICK HERE to join Massimo at RiskMinds International on 5th December at 9am to join him on a workshop about DLT & Crypto Currencies.
Custody Looking at Bitcoin, we can say for sure that there is one area where DLT has
It is difficult to predict where
a strong impact: custody, in the sense
technology will have most impact
of the “bank account” business and
on the financial industry. No one
similar businesses. There is no need
predicted that when mobile phones
for custody of digital assets when they
were introduced among the most
are registered in an immutable ledger,
impacted industries, photography was
public or in any case shared by all
affected the most. At the same time,
players interested in a given currency
not many people would have imagined
or asset. The account or custody
that even in the case of massive
business changes dramatically with
spread of mobile phones, we would
DLT. It does not necessarily wipe out
still have landlines because they give
intermediaries or custodians: if we look
us broadband internet access. This
at Bitcoin, we see that intermediaries
is particularly true when, like the
of all kind are flourishing, and many
case of DLT (the Distributed Ledger
players offer “wallet” services. This
Technology arising from Blockchain),
is the case even if, as we will explain
one is considering not a single
in the RiskMinds workshop that I am
technology but a mix of technologies
chairing on 5th December from 9am,
applicable to different use cases, some
there is no real “wallet” in Bitcoin, but
of which already stand out.
only a registry of the transactions that allows to see the “unspent transaction amounts” controllable by different private keys. Yet this business is much thinner with DLT: there is no longer the implicit lending to a bank which is typical of bank accounts, neither the
“The beauty of technological innovation is that the possibilities are endless.” 18
typical safety and management issues associated with custody of financial assets. Financial institutions are not necessary unhappy of this: it goes in the direction of narrow banking, a philosophy of banking characterized by smaller balance-sheets that was proposed over 10 years ago. Counterparty risk The Ethereum Blockchain and its smart contracts are, for all accounts, “robot counterparties” (a much fairer
name than “smart contracts”). They own money and they make transactions, following what is written in their management computer code. Since they are the real counterparty when we are using smart contracts on Ethereum, they are already changing our definition of counterparty risk, which is another area where we expect impact. In a transaction like buying a bond, the traditional counterparty risk is when you transfer the bond but then the other party does not pay the price, or the other way around. A smart contract can prevent it, by making the transaction atomic: a service or a transfer will be executed simultaneously to the corresponding payments, since the smart contract will hold one leg of the transaction until the other one has been paid by the counterparty. The same effect applies to transfer of collateral for derivatives; the smart contract can make cash flows and corresponding collateral exchange be simultaneous, preventing big misalignments between collateral and exposures. Smart contracts can also provide various actions in case a counterparty does not fulfil its obligations, and additionally DLT can shorten the clearing and settlement times, further reducing counterparty risk. While this does not mean we eliminate counterparty risk, the whole concept changes alongside the creation of different risks. Since the counterparty is a piece of code, it can be exploited by clever hackers, as seen in TheDao case! From the
Disruptive Innovation & The Future Of Risk Management. 8th December at RiskMinds International
Ethereum fork to CORDA smart
Regulations, market supervision,
contracts, that appear very differently
and compliance
to Ethereum’s insights in the recent
The above is already visible in some real
R3 white paper, start-ups are already
use cases. At the opposite end of the
working on solutions to the new risks
spectrum, in the sense that we will most
while strengthening the advantages
certainly wait years before seeing this
of the old risks. This is another topic
in practice, is the impact that DLT can
we will analyse in detail during the
have on regulations, market supervision,
RiskMinds workshop.
and compliance. In the last few years, regulators have committed to give the
Reconciliation and settlement
largest possible visibility to financial
Reconciliation and settlement disputes
transactions, such as derivatives. For
are likely to be impacted too, leading
example, when making a transaction,
to important changes to a system still
parties need to ‘send’ the details of
based too much on “consensus-by-
the transaction to a repository that
reconciliation”, a principle which is
will check correspondence with the
very old and brings risk, delays and
transaction sent by the counterparties.
capital consumption.
On a Blockchain, these steps are automatic when the transaction is
Contracts
written in the shared ledger: a unique
The impact on reconciliation and
representation, coinciding by definition,
settlement disputes is likely to be
will be visible to all nodes with the
impacted: contracts, also in their legal
necessary authorisation. It is possible
sense. Smart contracts are not only
that when regulators consider this,
interesting for automation, but also for
they will become strong promoters of
increased precision: we already have
distributed ledger technology, and will
templates for financial agreements,
ask Blockchain to be public or at least to
and financial contracts are already
be given the privilege to see everything
translated by parties into software
happening on private Blockchain. All
running on IT systems. Making this
compliance jobs may experience a
part of the contract is an avoidable step,
radical change in such a context.
that will make regulatory compliance easier. The contract stops being two
Having said this, and looking at past
pieces of papers to be implemented
history, I suspect that at least one of the
and represented in separate ways
above areas will be impacted differently
but become a unique manager of the
from expected, and that at least one
transaction signed (cryptographically)
area that will be strongly impacted is
by the interested parties. The smart
missing from the above list. The beauty
contract can be much more detailed
of technological innovation is that the
than current contracts, incorporating
possibilities are endless. We will explore
the algorithmic details of complex
all of these possibilities in the RiskMinds
contractual features and also legal
workshop, alongside case studies and
requirements and ISDA standards.
ways in which you can adapt your
Again, this is not going to be the end
business to the prospective changes.
of law supervision on contracts, or the end of “plain English” in contracts; the legal framework embedding smart contracts, and the way to address possible problems, must become much clearer than they are now, and this will
MASSIMO MORINI
keep lawyers busy for a long time.
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