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UK FSA Highlights Asset Managers’ Counterparty Risk Shortcomings and Valuations Independence

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As a follow up to its 2009 Financial Risk Outlook (FRO), the UK Financial Services Authority (FSA) has published a review of the derivative risk management practices in place across the investment management industry, which highlights the buy side’s valuations and risk management practices and related shortcomings. The study, which is based on data from 12 “independent” asset managers (rather than the asset management arms of financial institutions), indicates that these firms have significantly different approaches to areas such as counterparty risk management (with varying degrees of success) and that all of the firms have independent pricing processes in place.

Last year, the regulator noted that asset managers’ risk management resources left something to be desired, noting in the FRO: “There are concerns that firms may not have adequate resources in place to allow them to robustly trade, settle, value and risk manage the full range of investments within their mandates.” In particular, OTC derivatives were singled out as a particular area of deficiency and specific reference was also made to counterparty risk in light of the Lehman collapse.

Accordingly, this year’s FSA study indicates that the 12 firms that participated have differing definitions of counterparty and market risk and therefore: “the oversight processes varied greatly in frequency, content, and depth of analysis, particularly regarding unsettled trades, margin money and prime broker collateral monitoring. This issue showed the most divergent practices of the survey and so implies industry standards and good practices are still evolving in this area.” Risk management is in a state of evolution and this will have a significant impact on the data management function also.

The 12 firms’ overall approach to derivatives risk management range from a box ticking exercise to a more “comprehensive firm-wide risk process,” according to the FSA. It notes that a more joined up approach to risk is needed (with the spectre of enterprise risk management very much in the background) in order to avoid a whole host of problems: “Incomplete monitoring and fractured reporting of risks results makes it difficult for the firm to see a complete picture of its risks in a timely manner.”

The regulator is therefore seeking to tackle these shortcomings in particular and warns firms that it expects documentation to be available to demonstrate the “processes for the oversight of risk exposures across the entire business model, including activities which are outsourced,” which must be reviewed “at least annually”. In order to carry out this function, firms will need to be able to rely on the data quality within their risk systems and have sufficient data sets in place to prove that they have a handle on the derivatives they are trading.

The study also singles out communication as a shortcoming within most of the firms, with the risk function performing its duties but not clearly communicating these risks to business users and senior management. The FSA states: “A firm should ensure all directors have sufficient knowledge and information so that they can understand (as relevant) the fund’s, or the firm’s, market, counterparty and operational risks.” Control and sharing of this data is paramount to keeping out of the regulatory spotlight.

These buy side representatives may have fallen down on some of their risk management practices, but valuations is a different kettle of fish, with the FSA noting that it is an area “better and more consistently addressed”. The use of independent pricing sources is commended by the regulator in the study, as is the establishment of set procedures and performance standards in the case of illiquid markets .

“The majority of the firms had outsourced pricing to a third party, commonly the administrator, trustee, or fund accounting function. In these cases, service level agreements were in place regarding pricing procedures and the need for independent price sources. Five of the firms had in-house capabilities which produce prices independent of the front office. These were used as a check against the third party prices and occasionally as an indicator of which price to apply if multiple data sources are used. All of the firms surveyed had a formal pricing procedure in the event that usual pricing procedures fail,” states the report.

This indicates that the buy side and the regulator are aware of the importance of third party pricing sources and the notion of “independence” within the valuations function. However, the FSA does not make direct reference to the data standards challenges being faced by those in the valuations and risk management functions, such as around counterparty identification and supporting reference data. These are also important considerations to bear in mind in this context and issues that must be tackled by the industry in a cohesive manner.

In the meantime, the FSA is keen for the industry to view the report as potential “benchmarking data as to the status of derivative risk management processes and controls”. The full FSA report is available to view here.

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