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Managing Risk in Multi-Asset Class, Multimarket Central Counterparties : The CORE Approach Luis Antonio Barron G. Vicente Risk Management Officer May/2013. CLASSIFICATION OF INFORMATION (CHECK WITH AN “X”):. CONFIDENTIAL AND RESTRICTED. CONFIDENTIAL. INTERNAL USE. PUBLIC. X. AGENDA.

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slide1

Managing Risk in Multi-Asset Class, Multimarket Central Counterparties: The CORE Approach

Luis Antonio Barron G. Vicente

Risk Management Officer

May/2013

CLASSIFICATION OF INFORMATION (CHECK WITH AN “X”):

CONFIDENTIAL AND RESTRICTED

CONFIDENTIAL

INTERNAL USE

PUBLIC

X

slide2

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide3

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide4

RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES

  • DEFINING A ROBUST & EFFICIENT RISK MODEL

MULTI-ASSETCLASSANDMULTIMARKETCLEARINGHOUSES

OPPORTUNITY TO INCREASE EFFICIENCY VIARISK-OFFSETTING

Efficiency gains are not considered robust when the assumptions employed by the risk-offsetting model have a low level of adherence to reality, resulting in insufficient resources for the clearinghouse to fulfill its obligations

BUT HOW TO ENSURE THAT EFFICIENCY GAINSARE ROBUST?

NEED TO BUILD A RISK MODEL THAT REFLECTS, IN A REALISTIC WAY, THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE

slide5

RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES

  • THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE

IN THE EVENT OF A PARTICIPANT DEFAULT, THE RISK MANAGEMENT PROBLEM OF FACED BY A CLEARINGHOUSE IS TO HAVE THE RESOURCES AND LIQUIDITY NEEDED TO PROVIDE AN ORDERLY CLOSEOUT FOR THE SET OF POSITIONS HELD BY THE PARTICIPANT, UNDER CURRENT MARKET CONDITIONS, CONSIDERING A MINIMUM HOLDING PERIOD

PORTFOLIO CLOSEOUT PROCESS

...

T+0

T+2

T+3

T+4

T+N

T+1

MAJOR ASPECTS THAT SHOULD BE TAKEN INTO ACCOUNT BY THE MODEL

TRADING MODEL – ELECTRONIC VS OTC

EVOLUTION (INTERTEMPORAL DYNAMICS) OF THE RISK FACTORS THAT DEFINE THE VALUE OF THE ASSETS AND CONTRACTS INCLUDED IN THE PORTFOLIO, AS WELL AS OF THE PORTFOLIO COMPOSITION ITSELF

SETTLEMENT MODEL – RTGS VS DNS

LIQUIDITY/MARKET DEPTH

FRICTIONS, RESTRICTIONS AND OPERATIONAL FEATURES ASSOCIATED WITH EACH ASSET INCLUDED IN THE PORTFOLIO

CASH FLOW STRUCTURE OF THE ASSET

POSSIBILITY OF A FRACTIONAL SETTLEMENT

slide6

RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES

  • A MORE COMPLEX APPROACH THAN THAT OF MODELS BASED ON VAR

WHEN MODELLING THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE, ONE MUST CONSIDER, IN A JOINT FASHION, THE EVOLUTION OF THE MARKET VARIABLES (PRICES & RATES) AND THAT OF THE PORTFOLIO COMPOSITION, RESPECTING A SET OF SIGNIFICANT RESTRICTIONS IMPOSED BY THE CHARACTERISTICS OF EACH ASSET UNDER CONSIDERATION

PORTFOLIO CLOSEOUT RISK

  • P&LCALCULATION
  • DYNAMIC PROCESS WITH FRICTIONS

...

T+0

T+2

T+3

T+4

T+N

T+1

THIS TYPE OF MODELLING REQUIRES CONCEPTS AND TOOLS MORE COMPLEX THAN THOSE TYPICALLY EMPLOYED BY THE FINANCIAL INDUSTRY (I.E. MODELS BASED ON VAR). IN FACT, THESE MODELS OFTEN FOCUS ON MEASURING THE POTENTIAL VALUE OF A STATIC PORTFOLIO, WITHOUT TAKING INTO ACCOUNT A DYNAMIC CLOSEOUT PROCESS WITH FRICTIONS

VARIATION RISK OF THE PORTFOLIO VALUE

  • P&LCALCULATION
  • STATIC PROCESS WITHOUT FRICTIONS

T+0

T+N

slide7

RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES

  • A MORE COMPLEX APPROACH THAN THAT OF MODELS BASED ON VAR (CONT’D)

ALTHOUGH THE MODELS BASED ON VAR MAY BE ADAPTED TO ESTIMATE THE CLOSEOUT RISK, THEIR PLAUSIBILITY IS COMPROMISED WHEN MULTI-ASSET AND MULTIMARKET PORTFOLIOS (I.E. HIGHLY HETEROGENEOUS) ARE CONSIDERED

IMPLICIT CLOSEOUT MODEL

  • UNDERLYING HYPOTHESIS: ALL ASSETS & CONTRACTS ARE TO BE SETTLED AT THE SAME TIME WITHOUT ANY FRICTIONS, WITH FULLY COINCIDING CASH FLOWS

T+0

T+N

AN ALTERNATIVE APPROACH CONSISTS IN THE USE OF A MODEL BASED ON MULTIPLE SILOS, WHERE EACH SILO CONTAINS ONLY ASSETS AND/OR CONTRACTS WITH COMMON FEATURES (I.E. HOMOGENEOUS). IN THIS CASE, THE TOTAL PORTFOLIO RISK IS GIVEN BY THE ALGEBRAIC SUM OF EACH SILO.

IMPLICIT CLOSEOUT MODEL

  • SUM OF RISKS

T+0

T+0

T+0

T+N

T+N

T+N

  • ...
  • SILO 1
  • SILO 2
  • SILO 3
slide8

RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES

  • SILO MODELLING & SYSTEMIC RISK INCREASE

EVEN A MODEL BASED ON SILOS, WITH SUPERCOLLATERALIZATION VIA SUM OF RISKS, DOES NOT NECESSARILY ENSURE A MORE ROBUST SYSTEM. IN FACT, A MODEL BASED ON SILOS MAY HIDE IMPORTANT RISKS OF LIQUIDITY FRAGMENTATION AND REDUCE INCENTIVES TOWARDS THE ADOPTION OF A DILIGENT BEHAVIOR IN TIMES OF CRISIS.

ORIGINAL SITUATION,AGENTS “A” & “B”

  • COLLATERAL (RISK) = 100

T+0

T+0

T+N

T+N

  • SILO 1
  • SILO 2

INCREASED MARKET VOLATILITY

DISINCENTIVE TOWARDS A DILIGENT BEHAVIOR

AGENT “A” HEDGES SILO 2 RISK ON THE MARKET

  • COLLATERAL(RISK) = 200

LIQUIDITY RISK INCREASES IN THE SYSTEM

T+0

T+0

T+N

T+N

  • SILO 1
  • SILO 2

AGENT “B” DOES NOT HEDGE AT ALL

LTCM SCENARIOS (1998) & NTN-D CRISIS (2002)

  • COLLATERAL (RISK) = 100

T+0

T+0

T+N

T+N

  • SILO 1
  • SILO 2
slide9

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide10

THE CORE MODEL FOR RISK CALCULATION

  • THE CORE MODEL

THE CORE MODEL WAS SPECIFICALLY DEVELOPED BY BM&FBOVESPA TO ALLOW FOR ROBUST AND EFFICIENT RISK ESTIMATION IN A MULTI-ASSET CLASS, MULTIMARKET CLEARINGHOUSE

MAJOR FEATURES

CONSIDERS THE INTERTEMPORAL DYNAMICS OF THE PORTFOLIO CLOSEOUT PROCESS

CONTEMPLATES IMPORTANT FRICTIONS & RESTRICTIONS ASSOCIATED WITH THE SETTLEMENT PROCESS OF ASSETS AND CONTRACTS – TRADING DYNAMICS, MARKET LIQUIDITY AND DEPTH, CASH FLOW STRUCTURE, ETC

ESTIMATES, IN BOTH A JOINT AND A CONSISTENT MANNER, THE MARKET AND LIQUIDITY RISKS ASSOCIATED WITH A PORTFOLIO CLOSEOUT PROCESS

slide11

THE CORE MODEL FOR RISK CALCULATION

  • OVERVIEW: CLOSEOUT RISK CALCULATION IN THREE STEPS

Defines the portfolio closeout strategy which, respecting the settlement restrictions of the portfolio of assets/markets, should minimize the risk of a loss associated with the closeout process, preserving existing hedge strategies

1. DETERMINING THE CLOSEOUT STRATEGY

...

T+0

T+2

T+3

T+4

T+N

T+1

2. RISK EVALUATION

Defines the (stress) scenarios associated with the dynamics of each risk factor relevant to the portfolio. All assets and contracts are reevaluated considering the scenarios defined in this step (full valuation).

...

T+0

T+2

T+3

T+4

T+N

T+1

3. POTENTIAL P&L CALCULATION

Calculates and aggregates intertemporallyP&Lassociated with each scenario, considering the defined closeout strategy

...

T+0

T+2

T+3

T+4

T+N

T+1

CLOSEOUT RISK

PERMANENT LOSS

TRANSIENT LOSS

Result: Two risk measures—market and liquidity—that are estimated both jointly and consistently

slide12

THE CORE MODEL FOR RISK CALCULATION

  • OVERVIEW: PERMANENT & TRANSIENT LOSS

3. POTENTIALP&LDETERMINATION

...

T+0

T+2

T+3

T+4

T+N

T+1

EQUALS

PERMANENT LOSS

CASH NEED ON T+N

V0

V1

V3

V2

+

+

+ ...

+

V4

+

VN

V0

CASH NEED BY T+0

V0

V1

CASH NEED BY T+1

+

CASH FLOW AMOUNTS

TRANSIENT LOSS

CASH NEED BY T+2

V0

V1

V2

+

+

MAXIMUM BETWEEN

CASH NEED BY T+3

V0

V1

V3

V2

+

+

+

CASH NEED BY T+4

V0

V1

V3

V2

+

+

+

V4

+

CASH NEED BY T+N

V0

V1

V3

V2

+

+

+ ...

+

V4

+

VN

slide13

THE CORE MODEL FOR RISK CALCULATION

  • DETAIL: CLOSEOUT STRATEGY DEFINITION

T+0

T+5

T+1

T+2

T+3

T+4

CLOSEOUT

PORTFOLIO

FUTURES, BUY, IMMEDIATE SETTLEMENT

OPTIONS, SELL, SETTLEMENT ON T+3 ONLY

SWAP, SELL, SETTLEMENT ON T+5 ONLY

1

NAIVE STRATEGY

RISK

MINIMUM RISK

2

OPTIMAL STRATEGY DEFINITION

3

OPTIMAL STRATEGY

ITERATION

slide14

THE CORE MODEL FOR RISK CALCULATION

  • DETAIL: PORTFOLIO COMPOSITION & RISK FACTOR EVOLUTION

P&L ALONG THE PROCESS

T+2

T+0

T+1

T+3

T+4

T+5

T+6

CLOSEOUT

PORTFOLIO

FACTOR 1

FACTOR 2

FACTOR n

T+2

T+0

T+1

T+3

T+4

T+5

T+6

MARKET

RISK FACTOR EVOLUTION

slide15

THE CORE MODEL FOR RISK CALCULATION

  • DETAIL: RISK FACTOR EVOLUTION & MULTIVARIATE SCENARIO GENERATION

FACTOR 1

MULTIVARIATE

SCENARIO

GENERATOR

FACTOR 1

FACTOR 2

...

FACTOR 2

...

FACTOR n

FACTOR n

SCENARIOS TO DETERMINE P&L DURING THE CLOSEOUT PROCESS

T+0 – T+1 – T+2- ... – T+N

T+0 – T+1 – T+2- ... – T+N

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

...

# SCENARIO

RISK FACTOR

T+0 – T+1 – T+2 – ... – T+N

slide16

THE CORE MODEL FOR RISK CALCULATION

  • DETAIL: P&L DETERMINATION DURING THE CLOSEOUT PROCESS

WORST CASE SCENARIO

PERMANENT LOSS

TRANSIENT LOSS

#1

PERMANENT LOSS

TRANSIENT LOSS

#2

PERMANENT LOSS

TRANSIENT LOSS

#3

...

...

...

...

...

PERMANENT LOSS

TRANSIENT LOSS

#nSCN

POSITIVE FLOW

SCENARIOS

T+2

T+1

T+3

T+4

T+5

T+6

NEGATIVE FLOW

slide17

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide18

HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL

  • MAIN EXAMPLES

HEDGING AN OTC DERIVATIVES POSITION ON THE LISTED DERIVATIVES MARKET

CORE RISK

  • CLOSEOUT RISK

...

T+0

T+2

T+3

T+4

T+N

T+1

CURRENT MODEL

  • SUM OF RISKS

T+0

T+0

T+0

T+N

T+T

T+T

  • SILO 2
  • LISTED DERIVATIVES
  • SILO 1
  • OTC POSITION
  • SILO 3
  • COLLATERAL

CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO

CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (OTC) + RISK (LISTED DERIVATIVES)

slide19

HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL

  • MAIN EXAMPLES (CONT’D)

ASSET BEING HEDGED IS POSTED AS COLLATERAL

CORE RISK

  • CLOSEOUT RISK

...

T+0

T+2

T+3

T+4

T+N

T+1

CURRENT MODEL

  • SUM OF RISKS

T+0

T+0

T+T

T+N

  • SILO 2
  • COLLATERAL
  • SILO 1
  • LISTED DERIVATIVES

CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO

CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (LISTED DERIVATIVES)

slide20

HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL

  • MAIN EXAMPLES (CONT’D)

EQUITIES BORROWER HOLDING COLLATERAL IN SHARES OF THE SAME COMPANY, BUT OF A DIFFERENT TYPE(PREFERRED VS COMMON)

CORE RISK

  • CLOSEOUT RISK

...

T+0

T+2

T+3

T+4

T+N

T+1

CURRENT MODEL

  • SUM OF RISKS

T+0

T+0

T+T

T+N

  • SILO 2
  • COLLATERAL
  • SILO 1
  • EQUITIES LENDING

CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO

CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (LENDING)

slide21

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide22

CORE MODEL IMPLEMENTATION

  • MODEL COMPONENTS & IT ARCHITECTURE

OPTIMAL CLOSEOUT STRATEGY DEFINITION

SPECIFIC SOFTWARE TO DEAL WITH OPTIMIZATION ISSUES

PRICE GENERATION BASED ON MULTIVARIATE SCENARIOS

VERY HIGH PERFORMANCE PARALLEL ARCHITECTURE USING GRAPHIC UNITS WITH MULTIPLE PROCESSORS (GPUs)

RISK AGGREGATION &CONTROL

HIGH PERFORMANCE SOFTWARE DEVELOPED IN C++ BY BM&FBOVESPA

INTERFACE WITH THE RTC PLATFORM (CINNOBER)

RISK PLUG-IN DEVELOPED BY BM&FBOVESPA IN TANDEM WITH CINNOBER

slide23

CORE MODEL IMPLEMENTATION

  • TEAMS INVOLVED

FINANCE CONCEPTS (MR. MARCO AVELLANEDA/NYU & MR. RAMA CONT/COLUMBIA)

INDEPENDENT ASSESMENT, FEASIBILITY ANALYSIS, SUPPORT TO MODEL DEFINITION

RISK MANAGEMENT OFFICE

MODEL DEFINITION, PROTOTYPE CONSTRUCTION, DEFINITIVE MODEL TESTING

IT OFFICEPOST-TRADING

CORE MODEL DEVELOPMENT

slide24

CORE MODEL IMPLEMENTATION

  • PROJECT STATUS - MACRO

CONCEPTUAL MODEL

MATHEMATICAL MODEL

PROTOTYPE

RISK PLUG-IN/CORE

JUL2011

JUL2010

DEC2011

DEC2012

MAR2013

DEC2010

PROTOTYPE PRESENTATION

slide25

AGENDA

  • RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
  • THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
  • HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL

CORE MODEL IMPLEMENTATION

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

slide26

KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION

DEVELOPED SPECIFICALLY TO DEAL WITH THE RISK MANAGEMENT PROBLEM FACED BY CLEARINGHOUSES

ROBUST MODELLING PROVIDING EFFICIENCY GAINS WITHOUT GIVING UP SAFETY

TRANSPARENT & INTUITIVE MODEL – ASSUMPTIONS CA BE EASILY VALIDATED

MARKET & LIQUIDITY RISKS ARE TREATED IN BOTH A JOINT AND A CONSISTENT MANNER

GREATER EFFICIENCY IN CAPITAL ALLOCATION FOR PORTFOLIOS WITH RISK MITIGATION STRATEGIES (HEDGE)

INCENTIVES TO THE ADOPTION OF PRUDENTIAL MEASURES TO MITIGATE RISKS

CIRCUMVENTS THE SILO APPROACH, SO LIQUIDITY FRAGMENTATION IS AVOIDED AND SYSTEMIC RISK MITIGATED