The many risk elements intrinsic to a fixed income transaction interact in almost infinite combinations across the various markets in which the asset class is traded.
Indeed, many finance professionals have devoted their energies and careers to the proper identification and management of these risk variables and elements. Over the last decade, we have seen a number of significant market events concentrate the industry’s focus on the cause and effect of those variables for significant periods, particularly those in the credit and market risk categories.
However, in my humble opinion not enough energy and focus has been applied to the holistic view of operational risk, a risk profile that has arguably changed more than any other in the last decade.
Multiple changes in the very fluid operational risk profile of fixed income instruments have stemmed from global regulatory reforms, trends in investing globally, shortened settlement cycles, and the use of varied instrument types in the quest for alpha and outperforming benchmark indices.
These ongoing and significant changes mean that firms looking to trade effectively across multiple fixed income markets need to have a full understanding of the operational and related risk elements they encounter across the lifecycle of the transaction, from idea generation and trade execution in the front office, to settlement, accounting and reporting in the back office.
Operational risk management is often considered a back-office responsibility that, like a computer system, must always be up and ever vigilant. But in reality the pre- and post- execution operations cycle is made up of many moving parts. In fact, DTCC research highlights roughly 10% of all global fixed income transactions are not matched, confirmed and locked in for settlement on trade date, quite a large aggregate global exposure for this market and industry at large.
These operational shortcomings not only cause back-office headaches but can also severely constrain the ability of asset managers to implement investment strategies. The time is right to introduce a new concept – transactional risk analysis (TRA) – based on a thorough understanding of risk categories including credit, market, interest rate, liquidity and operational risk. In this chapter, we will investigate TRA in more detail and explain how it can improve the overall efficiency of the fixed income investment and trading process.
Constructing the transaction operational risk profile
In our journey to manage operational risk, we must first properly define each broader functional category and underlying risk variable across the fixed income trade life cycle, noting that execution of these tasks are most likely assigned organizationally to an operations or compliance team, not the fixed income trading desk itself. Furthermore, these risk profiles and characteristics can and often do vary across different fixed income instruments and markets (e.g., corporate, muni, mortgage, financing or repo transaction).
How best to group different categories of risk? What should be the key operational focus areas? Below we propose some high level groupings and associated key activities:
Pre-trade
Before any securities market participant enters into a transaction, a number of pre-execution checkpoints and processes must be completed, some mandated by regulation that varies by jurisdiction.
Having the account or owner properly documented and open for trading activity can ensure both regulatory and counterparty certainty in the trade processing life cycle and in some instances avoid costly penalties that can wipe out business returns on the transaction.
Trade or execution date
Fixed income transactions are often conducted in very high denominations – exceeding US$1 billion in the financing or institutional repo markets – and represent a great risk to each firm. As such, it is imperative to use a standardized and automated process with highly well-defined confirmation and internal controls on settlement.
Immediately after execution, a critical task in the fixed income market is the ‘block checkout’, a process whereby each counterpart agrees the key details of the transaction, such as counterpart, security and settlement information and its economic components. Subsequently, the block or aggregate transaction can be broken down or allocated to individual accounts, which may be owned by different legal entities, each potentially specifying different locations or central depositories.
The operational teams are required to facilitate the transaction’s progress along the trade life cycle in order to provide as much certainty in settlement as possible.
The DTCC European Fixed Income community recently provided feedback that trading desk behaviour is the largest contributing factor to the failure of fixed income market participants to match and confirm trades on trade date. It is critical to both the individual firm and the market at large to ensure rigour and discipline is deeply embedded at each step of the investment process.
Trade netting and central counterparty (CCP)
In trade netting, many similar transactions are combined to net down individual security exposures to an aggregate level which reduces the number of physical settlements. This allows firms to manage the credit exposure by security more efficiently while reducing settlement risk and costs.
Similarly, in central clearing, the central counterparty steps in and acts as the buyer to every seller and seller to every buyer, while imposing a market risk management process that is more efficient than a bilateral ‘trade-for-trade’ exercise undertaken with each counterpart, thereby reducing counterparty risk for individual trading counterparts and the overall market.
In today’s fixed income market, netting and central clearing are used primarily in dealer-to-dealer clearing and settlement channels. But the buy-side is becoming more aware of the benefits of these processes and how they can be applied to the institutional transaction chain to also reduce risk and costs.
Collateralisation
The process of Collateralisation is a post settlement life cycle activity that ensures sound fiduciary responsibility while also fulfilling required regulatory compliance for various fixed income products such as ‘TBA’ mortgages, repos, bond and rate futures as well as OTC derivatives. An efficient process must be established for storing critical counterparty documents like master securities forward transaction agreement, credit support annexes and others. Once the legal narrative is fully captured and stored, daily operational execution can occur.
It is critical to have an automated process that can determine the appropriate market values, negotiate and deliver on collateral movements to secure the appropriate interest. These activities can be fairly highly standardized for each product type and across the global marketplace and could potentially leverage a shared and common infrastructure.
Often the cash bond trade has a companion hedge or contract and both are marked to market daily for accounting and Collateralisation of the hedge, often an OTC derivative contract. Sound operational processes can be a significant part of the transactional risk management of the firm.
Trends impacting operational risk in the middle and back office
The multi-faced and diverse fixed income universe is constantly changing, throwing up new challenges on a weekly if not daily basis, in terms of operational risk.
DTCC has developed a community user base by broadly engaging with clients to create awareness of automation opportunities as well as collaborating to solve common challenges. We are working with our fixed income communities in US, Canada, Europe and Asia to address common issues through community solutions, thereby steering product and market developments.
Topics we have recently identified for further discussion and development include: trade date exceptions in areas including new issue corporate bonds; trading desk behaviours including timely trade capture, risk and operational implications of cross currency bonds; as well as pre-trading account openings.
We have seen record volumes in the new issue corporate bond syndication in recent years, in response to the prevailing low interest rate environment. In many respects, this has been a positive development for many segments including brokers, asset managers and corporations themselves. Corporate participation in the fixed income markets has definitely been on the upswing, in terms of refinancing balance sheets. At the same time, asset managers have been highly keen to participate or buy allocation in these new corporate bond placements as
a means to provide their accounts greater returns and also surpass the indices that often don’t embed these offerings for 90 days.
However, new corporate bond issues can bring operational challenges as the process of securing an allocation in an new instrument is not as proven as seasoned, secondary market transactions, particularly with respect to the all critical security identifier, i.e., ISIN or CUSIP.
Often, the new security’s identity is not widely disseminated on execution date, which cam leave back-office teams scrambling to set up and establish the security on settlement paths as well as books and records.
Recent global market liquidity challenges
Market liquidity challenges can often require market participants to identify the location of the security in a compressed timeframe in order to deliver and avoid a fail, which can carry a hefty financial penalty in some markets.
Operations teams on both sides of the transaction, i.e., delivering or receiving, must be alert and persistent within their respective organizations to ensure the bonds are on a path to good delivery. This risk is exacerbated by the recent compression of securities settlement cycles to T+2, impacting the corporate bond market the most as largely currently in a T+3 environment.
Furthermore, liquidity challenges in the major bond markets have led asset managers to use the bond futures market more extensively to buy or take-on the same risk as the cash bond trade. More risk is introduced, at least initially, with any new trading process or instrument and raises some questions: is your middle and back office ready and able to support these transactions? Can any of your trading system or back-office partners fully support these trades? What are the operational risks and are they properly captured and supported with the right operations risk internal controls?
Geographic risk
One of the trends in the fixed income markets the last decade has been the acceleration of global bond investing. We have seen growth in this area for a number of reasons including the broader search for alpha in the low-interest rate environment, the displacement caused by the European sovereign bond crisis and the advent of many new emerging market funds.
The growth in this area has caused operational teams to identify and manage global investing risks each day in settling and maintaining these transactions on the books. Some of the challenges introduced by global investing include, but are not limited to, disparate time zones, longer settlement agent chains, interaction with local depositories, local rules and – last but certainly not least – the risk management processes of the FX market (yet another product type with unique operational risks and challenges). If it is not properly managing, the currency risk can sometimes negate returns on the underlying asset.
How industry utilities can help
While many front office and revenue generating centres can often dominate a firm’s capital budget, the pace and scale of recent developments in the fixed income markets confirm the crucial importance of investing in proper tools and processes for transactional risk management across the trade life cycle. The failure to do so can catch up when you least expect.
As history has repeatedly taught us, we are only as strong as our weakest link in the transaction risk management chain. This weakest link can arrive at our doorstep very quickly and comes in the many forms, from the counterpart themselves or a weak internal control checkpoint in the operational life cycle, which can ripple into a broader market disruption. For this reason, DTCC will continue to work with industry partners to develop integrated solutions that drive down processing costs, reduce systemic risk and minimize duplicative infrastructure investments.
Adaptive change in response to industry needs is top of mind at DTCC. We are looking at risk management holistically in the each of the risk categories discussed in this chapter. Certainly transactional risk analysis discussed in the is paper could be further developed by the industry in a similar vain to transactional cost analysis as a means to properly identify risk holistically across organizational silos. We stand at the forefront of innovation to mitigate risk, create market efficiencies and reduce costs. Furthermore, we believe that utilities have a uniquely important role in building and maintaining the processes and services on which the financial markets can grow on a stable and consistent basis.
This article was written by Kevin Arthur, director of fixed income and derivatives DTCC for The TRADE’s 2015 Fixed Income Handbook.