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Topic of the week: How to tackle risk?

Release date: 16 Apr 2019 | Eurex Exchange, Eurex Clearing

Topic of the week: How to tackle risk?

Risk management is all about identification, assessment and prioritization of risks, followed by a coordinated, economic use of resources to develop and execute the strategies to manage the risks i.e. control the probabilities and impact of losses. It is also about continuous re-assessment and improvement of risk management capabilities to cope with new emerging risks. So much for the definition. But what specifics risks is Eurex facing, how do we prepare for them and what risk management solutions do we have in place? We asked Thomas Laux, Chief Risk Officer of Eurex Clearing and Dmitrij Senko, his designated successor.

Thomas, what kind of risks does Eurex need to prepare for in particular?

Well, our key value proposition is to ensure the continuity of the markets. The risk we are facing as a market infrastructure provider is that we are unable to fulfill our services either to individual participants or to the whole market. So, continuity is key and we in first place need to ensure that we can manage operational risk, for example, that the system is not available, people are not there or there is an error in a system, a process, or a human error e.g. the much-quoted fat finger.
The second important source of risk we have is related to failures of individual members to fulfill their contractual obligations, what is known as counterparty risk management. The role of the CCP is to protect the market against this. We need to make sure that if players fail, like it happened to Lehman or Maple Bank for example, do not affect the whole business. We are not only managing risk for ourselves, we are also managing risk for our clients and the markets.
The third important risk category is liquidity risk, i.e. to ensure that we have enough cash available to pay our obligations out of settlement, clearing cash flows, etc.

Dmitrij, has the nature of risks changed over the years?

The clearing industry has changed over the last years, but main risks still fall in the same buckets operational risk, credit risk and liquidity risk. On the operational side, the sources of risk have changed. Information security risk is becoming more prominent – cyberattack is the buzzword to name here. On the financial risk side, the structure of participants is changing, so we have more buy-side participants becoming active and becoming direct members. In addition, as risk management capabilities have developed over time, some sources of risks have been mitigated and the focus shifts to higher order risks. For example as plain-vanilla credit risk is well managed with our Risk Management Framework (margins, default fund, etc.), further topics like interconnectedness of large members and the concentration on large members gain on focus in industry discussions. Risks and Risk Management are becoming increasingly nuanced, and this will continue in the future. If you had asked, say five years ago what the main risks were, the answer would have been macroeconomic, low interest rates and regulation. Today we increasingly talk about political risks – rise of populism, Brexit, trade wars, de-globalization/fragmentation, and Cyber.

Thomas, which risks are foreseeable and how can you prepare for them?

There are always things that you don’t know. However, on the other hand you need to be aware of what you do not know and try to be prepared to the extent you can. The tricky part is when you are not aware that you do not know certain things. Then it hits you completely out of the blue and you are unprepared. But there will always be uncertainty and risk management is a lot about working and dealing with uncertainty, which is part of the job. That is why there is not always a concrete black or white answer to certain scenarios. You need to prepare as well as you can, simulate scenarios even though they may seem far-fetched at first. That is why risk management is not just about calculating a value-at-risk. It is an ongoing process of watching the business environment, watching what has changed and what this means, identifying new sources of risks and developing and implementing the right risk management strategies for protection.

Dmitrij, what risk management systems do we have and how do they work?

We have several systems to manage counterparty credit risks in our role as Central Counterparty.
First, and most widely known is our Prisma Margining system. In our fast changing environment positions in portfolios and market data change very quickly and we need to have near-real-time margins calculated for each portfolio. We need to maintain sufficient margin collateral to cover Risk Exposures, so that we are able to act quickly when new developments happen. Second, we have Stress Testing system in place to run more severe scenarios on portfolios to check for risks not covered by margins. Such residual risks are covered by Default Fund all members contribute collectively. Third, we have the system to monitor concentrations and other type of adverse constellations that may arise across portfolios, collateral securities, members belonging to the same group or same country, just to name few dimensions that we look at. In addition there are also softer items we look at like share prices and credit spreads our members, news from Bloomberg, etc. Fourth, we have a set of tools that support important steps of Default management process like hedging and auction. In addition, we have systems and tools in place that support the process of Risk Model development and maintenance, like developing risk model adaptations to cover new products, and also Model Validation, like back testing and parameter sensitivity testing.
Looking ahead, there is also a huge opportunity for risk management in advanced analytics, machine learning and all these new technologies. For example, these can effectively scan trough thousands of portfolios, positions, potential concentrations, identify regime changes quickly and revert risk managers attention where it should be reverted. By this means, new emerging risks can be identified more quickly and risk manager has more time to develop and implement adequate risk management response. Just to highlight – it is not about algorithms, it is about people supported by technology – a combination which has been key success factor for a risk management function in the past, and even more so in the future.

Thomas, what kind of risks will we have to face in the near future and how can we prepare ourselves?

At the moment, Brexit is dominating everything because it will come soon. Everybody is preparing for Brexit. In our case, we have a set of measures we have implemented to make the transition from regime one to regime two as smooth as possible for our participants. As an organization, we also have to prove how we prepare for and tackle cyber risks. There is still a lot of work ahead, as everybody – suppliers, clients – has to act in tandem because we have a common interest here. Most likely, the situation will evolve and we will have to adapt to it. Political risks will, from my perspective,  continue in the near future and these kinds of risks are hard to prepare for. Because it is not rational, it is political and emotional which can lead to some very weird scenarios.
One main factor about being prepared is to have good staff who have the right skills. In the end, it is always people who need to design the systems, to manage the processes and be prepared and pro-active in addressing whatever events might arise. It is all about having the skills, the right people and the right risk culture.