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Firms Being Forced to Invest in Counterparty Risk Systems Due to Business Concerns, Says Algorithmics

Rather than pressures related to regulation, the business concerns of the front office are driving a spate of investment into revamping firms’ counterparty risk systems, according to a recent survey conducted by risk solution vendor Algorithmics. The investments are focused largely on credit value adjustment (CVA), which allows for more dynamic pricing of counterparty credit risk into new trades, says Bob Boettcher, senior director of product strategy at Algorithmics.

This backs up the findings of another survey conducted by Fitch Solutions and released last month that highlighted the shortcomings of current counterparty credit risk assessment methods. Firms are actively reassessing their traditional approach to counterparty credit risk in light of the financial crisis and rather than merely setting credit limit controls, they are now altering their pricing to take into account these risks.

“Many institutions are pricing CVA into trades at deal time, and are investing heavily to enhance their counterparty risk system capabilities,” says Boettcher. “When institutions have the ability to calculate real-time incremental CVAs rather than relying upon simple CVA add-ons, they gain the ability to price trades that lead to risk reduction more aggressively than risk increasing trades. We see much of the push for incremental CVA coming from the front office, with traders concerned that the inability to properly assess CVA is resulting in lost business due to the use of simple, overly conservative charges.”

The vendor’s survey indicates that a surge of investment has gone into reconfiguring and buying in new systems so that firms can more accurately assess CVA, and integrate CVA into pre-deal pricing and structuring. “Their expected return on investment is the ability to support future growth by freeing up more capital and minimising earnings volatility,” says the Algorithmics white paper, which is based on one to one interviews with a “cross section” of firms.

According to 67% survey respondents, their firms have completely re-evaluated their approach towards counterparty risk over the last two years and the remaining 33% have changed their attitudes in specific areas. The biggest area of concern, by far, is in collateral management, which was cited as the most important factor by just over 80% of respondents, with IT systems close behind, at over 70%.

Boettcher elaborates on the trends he has identified: “Counterparty credit risk has rapidly become the problem of all financial institutions, big or small. We see institutions changing their approach to counterparty risk with improvements to the traditional methods for measurement and control and many are now starting to implement CVA programmes. Proper management of pre-deal pricing and transaction structuring can provide firms with a competitive advantage and pioneering firms that accurately assess and integrate CVA within their risk culture are better able to pursue an overall risk strategy by providing transaction level incentives for the front office.”

According to survey respondents, collateral requirements are being tightened and most institutions see the ability to handle collateral more effectively in CVA calculations as key to future success. Furthermore, being able to capture all products, in particular exotics, within a counterparty risk system is a high priority for these firms. There is also a certain amount of emphasis on understanding and managing wrong-way risks in the market with regards to credit derivatives and the failure of monoline insurers.

“Many institutions are pricing counterparty risk based on their own default (DVA), and are examining the best way to manage this component,” says the paper. CVA is used for accounting purposes by just over 80% of respondents, fair pricing of trades by just over 70%, reducing reliance on credit limits by 55% and charging for unexpected losses by 45%.

Up until now, institutions have seemingly failed to put sufficient focus on counterparty credit risk, largely due to the concept of too big to fail, says Algorithmics. Many institutions relied only on limits as a means of preventing the exposure to any single counterparty becoming excessive, but did not actively price or manage the underlying risk, contends the vendor paper. Although some financial institutions used CVA to price the counterparty risk in their derivatives books, there was no recognition of their own potential default.

CVA has now become an important factor in tackling these challenges and it is being calculated on a fairly frequent basis by most: 50% of respondents indicated they calculate it monthly, 25% daily and 25% on an intraday pre-deal basis.

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