Managing OTC Derivatives Risk: Building Capabilities to Tame the Giant

by Cubillas Ding, September 17, 2008

Abstract

London, United Kingdom 17 September 2008

Managing OTC Derivatives Risk: Building Capabilities to Tame the Giant

Celent presents best practices in managing OTC derivatives risk and urges firms to develop capabilities beyond current operational infrastructure improvement efforts.

Financial engineering as a discipline has grown in scope, application, and visibility in recent years, driven by rapid innovations in financial instruments, a growing appetite by investors for tailored deals in the form of structured derivative-based products, and advances in the use of active portfolio risk techniques (e.g., risk transfer, securitization). Innovative risk management methods that financial engineering have unleashed in capital markets through over-the-counter (OTC) derivatives wield a double-edged sword: although derivatives are seen as tools for financial risk management, the instruments themselves expose firms to risks.

The recent woes in the financial services industry have undoubtedly resulted in stronger risk management frameworks becoming a more pressing issue to be tackled by both buy-side and sell-side firms. While progress is being made, it is imperative for firms to adopt a risk management framework to deal not only with risks associated with operational infrastructures but also with other risk factors and dimensions. In a new report, Managing OTC Derivatives Risk: Building Capabilities to Tame the Giant, Celent makes recommendations for best practice frameworks to be applied in tandem with implementing OTC solutions to tame this giant.

If there is anything to be learned from the 2007 credit crisis, it is that firms need to pay sufficient attention to the more speculative, wild west parts of the business, such as OTC derivatives (where product innovation and complexity are rampant, and operational controls comparatively less defined). Otherwise, the consequences could be dire...in many cases throughout the subprime crisis, a relatively small section of the business has generated a disproportionately large bulk of losses for the entire firm.

"So far, firmwide and industrywide initiatives have largely been focused on plugging gaps in operational infrastructures in areas such as trade flow processing, matching, and settlement," says Cubillas Ding, Celent senior analyst and author of the report.

"Although derivative instrument risks cannot be eliminated, firms can build capabilities to reduce and control unintended risks," he adds. "The hot spots specific to OTC derivatives encompass areas such as data management, model management, valuation and pricing, collaterization, reporting, limits management, payments, and portfolio reconciliations."

In this report, Celent also highlights the considerations and guidelines that need to be taken into account when selecting and implementing solutions in this area of OTC derivatives risk management.

The 70-page report contains 15 figures and 5 tables. A table of contents is available online.

of Celent's  Finance & Risk research service can download the report electronically by clicking on the icon to the left.  Non-members should contact info@celent.com for more information.  

Celent is a research and advisory firm dedicated to helping financial institutions formulate comprehensive business and technology strategies. Celent publishes reports identifying trends and best practices in financial services technology and conducts consulting engagements for financial institutions looking to use technology to enhance existing business processes or launch new business strategies. With a team of internationally based analysts, Celent is uniquely positioned to offer strategic advice and market insights on a global basis. Celent is a member of the Oliver Wyman Group, which is a wholly-owned subsidiary of Marsh & McLennan Companies [NYSE: MMC].

Media Contacts

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Michele Pace
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Table of Contents

London, United Kingdom 17 September 2008

Managing OTC Derivatives Risk: Building Capabilities to Tame the Giant

Executive Summary 3
Introduction 4
Background 5
  Emergence of OTC Derivatives 6
  Current State of Affairs 8
Operational Issues, Pain Points, and Business Imperatives 10
  OTC Derivatives Trade Processing 10
  Trade Processing Steps 10
  Supporting Functions 14
  Enhancements to OTC Derivatives Post-Trade Processing 15
Mapping Target Risk Management Capabilities for OTC Operations 17
Recommendations Towards Best Practice Frameworks for OTC Derivatives Risk Management 25
  Organization/People 26
  Models and Analytics 30
  Data 34
  Technology 36
  Reporting 37
  Compliance 40
OTC Derivatives--The Search for Risk Management Solutions 42
Expected Evolution of Vendor "Constellations" in the OTC Space 47
Conclusions / Looking Forward 51
Appendix A--Risks Created or Borne by OTC Derivatives 52
Appendix B--Representative Risk management Solutions for OTC Derivatives 58
Appendix C--Illustrative Example: Credit Default Swaps 65

 

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