By Rick Enfield, product business owner at Asset Control
The rise of alternative investment classes and derivative products corresponds with an increase in the number of counterparties financial institutions are dealing with today. While financial institutions have kept a close watch on systemic and operational risk factors, additional levels of investment complexity, coupled with a shaky economic environment, have put a new emphasis on the “other” KYC – know your counterparty – and the potential for exposure to counterparty risk. To properly assess any potential counterparty risk, financial institutions are reliant on clean counterparty data, centrally and properly managed.
One product that is highlighting the need for greater, more robust counterparty data management is the credit default swap (CDS). These products are intended to cover losses to banks and bondholders when companies fail to pay their debts. As a looming economic downturn strains companies’ finances, CDSs are being put to the test. The New York Times reported earlier this year that the outstanding value of the swaps stood at more than US$45.5 trillion, up from US$900 billion in 2001. Simultaneously, the spread for CDS contracts on 15 of the largest CDS dealers is increasing and CDSs are facing a higher risk of default, according to a report released by Credit Derivatives Research.
The potential for counterparty default in a CDS contract enters into the risk management formula considerations unique to these derivative products. Whereas the failure of a bond issuer impacts the holder of the specific debt obligation, the failure of a CDS counterparty to honour its obligation – for whatever reason – can also impact the integrity and valuation of the CDS market itself. If a major CDS counterparty severs its obligations, as promised under the original CDS contract, due to questions surrounding proper novation on the transfer of the obligations to other parties, the final beneficiary owner bears the burden of the default risk. Because a single entity can serve other entities in so many different ways, exposure to risk is not limited to counterparties, but rather, extends beyond them to include added exposure to operational and balance sheet risk.
The increased risk exposure on potential CDS defaults provides urgency in the need for financial institutions to capture accurate and complete hierarchical counterparty data in a centralised and controlled environment, with accessibility throughout the organisation’s disparate systems. This data includes CDS spreads, detailed credit information, on and off balance sheet positions and the critical data surrounding this relationship and its related entities. Even data elements that would not otherwise be associated with counterparty data – such as the above referenced CDS novation information – have counterparty exposure implications.
To properly know their counterparties, firms are sourcing data from a myriad of sources – both internal and external – to provide their risk management engines with a complete picture. However, firms face a number of stumbling blocks in their ability to consolidate data, distribute it to the many disparate applications that use the data, and deal with corporate actions.
The key is centralised data management. A central data platform ensures different data from different sources is clean, complete, available and useful in order for the organisation to properly assess its exposure. Such a platform bolsters the firm’s ability to leverage the strengths of the individual applications it relies on every day and ensures the organisation can properly assess its exposure. There is also enormous power in the ability to have a configurable platform to match and normalise data, to help firms leverage their data and turn it into actionable information.
A properly organised and managed central data platform arms financial institutions with the tools they need to alleviate counterparty risk through the integration of numerous data feeds that provide different types of data. With the data cleansed and properly routed, investors in credit products can better tune their internal risk management engines to avoid costly defaults.
Basel II and other regulations remain key drivers for action when it comes to counterparty data. Going forward, the market will demand more transparency and more standardised ways of reporting, and effective data management tools will help to achieve these goals.
With more than 25 years of experience in the financial services industry, Rick Enfield develops and implements solution strategies for Asset Control’s AC Plus data management software products.