Risk Management

02:15 PM
Mitchel Kraskin
Mitchel Kraskin
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Catch Me if You Can: Risk Hidden in Plain Sight

The digital revolution hasn't yet reached all four corners of the enterprise. Paper-based data and manual workflows are hotspots for risk and are ripe for modernization.

At the very start of my career, I became a junior fixed-income derivatives trader for a large investment bank. Upon graduating from the bank's management training program, I was awarded a trading desk role and handed state-of-the-art technology to manage the risky business of hedging risk. It was an HP 12c calculator with the bank's logo engraved on it. I was told to figure out how to program it to calculate options prices (Black Scholes algorithm) and then the "Greeks" (Delta, Vega, Theta, Gamma). Within a few hours, I had completed the task, and I felt confident that I was ready to learn the finer points of derivatives trading and portfolio risk management.

In retrospect, we clearly lacked the tools to manage the risks we faced -- and they were hidden in plain sight in a huge stack of paper we created every day. After pricing a trade on the HP and executing it, we filled out three-part carbon paper tickets, which were taken to the back office for booking and settlement, and we recorded our positions on a paper ledger. We received a printed report the next day from a back-office Dec Vax "mini," and we were told to reval our positions nightly using our "best guess" as to where these OTC trades would be fairly valued.

The weakness of this workflow is now obvious and came into sharp focus during the stock market crash of 1987, when investment banks' poor risk controls were widely exposed. In a single day, we lost our entire P/L for the year, and we never made it back, because we were short volatility in a rapidly rising bond market. Some months afterward, I requisitioned an IBM XT personal computer and an early-stage spreadsheet product called Visicalc. Using these tools, I created a dynamic risk model. This "what if" model showed me what a 100+ basis point move in any direction would do to my P&L and my Greeks. This was Risk Tech 101 but a huge improvement nonetheless over the HP 12c.

Black Monday in 1987 was a learning opportunity, and it has stayed with me ever since. I've developed additional instincts about where to find risk in both obvious and less obvious locations across the business enterprise. The obvious is to look at manual processes that are often paper-based and hence analog (form driven or unstructured). This approach is as valid today as it was on the desk 27 years ago. Yet, surprisingly, the digital revolution has still not reached all four corners of the enterprise.

As my product team searches for commercial opportunities, I ask them first to look across organizations for large stacks of paper. Several years ago, we came to the conclusion that, though much of the trading workflow has become digital and thus supported by real-time monitoring, the departments in close proximity to the trading desk (compliance, legal, sales & marketing, etc.) have not necessarily gone through the same modernization. We launched several products in those areas to capture and normalize the paper-based data in those backwater areas. Our work is not done -- we continue to find stacks of risk (paper) that are by and large ignored.

A bit less obvious in the search for risk hotspots is the notion that capping risk in one area often pushes the risk downstream to another. A great example is the recent academic study conducted by professors from New York University's Stern School of Business and McGill University, showing that the business of M&A is rife with insider trading abuse. The study found that as many as 25% of M&A transactions from 1996 through 2012 coincided with unusual call option trading activity ahead of the post-announcement price spike (a.k.a. classic insider trading).

For years, the Securities and Exchange Commission and the chief compliance officers at major investment banks have often focused on underwriter's risk (investment banking staff using material nonpublic deal information to front run deals). However, they by and large have ignored the risk of the "paper trail" within the rest of the M&A ecosystem -- law firms, accounting firms, consulting firms, etc., all of which may possess sensitive nonpublic information leading up to deal announcements. What good does it do to supervise a restricted list when only 25% of the parties under the tent are subject to scrutiny? Temptation is not the exclusive province of investment bankers. The same risk detection techniques that have curbed abuses for more than 15 years in the banking community have unintentionally relocated that risk to adjacent communities.

Ironically, we all need to be sensitive to an additional plain-sight risk environment within the risk technology platforms themselves. The days of a well-intentioned, homegrown point solution are waning. The fintech community is at the vanguard of understanding the set of risks on a broad scale. Now, more than ever, collaboration between the internal risk management team and the technology community is necessary to ensure that all aspects of risk are accounted for and mitigated. The nature of risk is that it migrates and morphs. Effective risk management programs require vigilance and an ongoing commitment to tracking and detection.

Can I interest anyone in a used HP 12c?

Mitchel Kraskin is co-founder and CEO of Compliance Science, Inc. ("CSI") which has developed several groundbreaking governance, risk management and compliance solutions. With over twenty five years of executive experience managing the creation and delivery of software-based ... View Full Bio
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Becca L
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Becca L,
User Rank: Author
7/31/2014 | 5:14:08 PM
Re: Scary


This article is rather scary, and to Ivy's point, at WS&T cover great enhancements in this area all the time, but there a lot of corners of the offices have been overlooked by both us and the firm! Somewhere at a major firm, right now, some one is keying away into a TI trying to hit a deadlin.



 
IvySchmerken
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IvySchmerken,
User Rank: Author
7/21/2014 | 1:50:41 PM
Re: Scary
It is scary to think that risk management was in the hands of basic calculator but then Mitchel upgraded to the IBM XT and VisiCalc, which was state of the art at the time.  Fast forward to today and banks have very sophisticated software to monitor risk in real time, at a point when markets are moving much faster and with exponential volumes of data. But it sounds like the gaps are in the surrounding departments- legal, compiance, marketing, sales. Since we endlessly write about compliance systems and CRM, I thought these areas had gone somewhat electronic.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
7/21/2014 | 6:28:07 AM
Scary
Mitchel, great back story on how quickly risk has gone from a back office afterthought to something that all firms should be thinking about right from the start of the trade. It's scary to think that large banks were "guesstimating" risk for years and the only tool they were using was an HP 12c.

 

HP 12c Calculator
IvySchmerken
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IvySchmerken,
User Rank: Author
7/19/2014 | 2:28:42 PM
Re: Opportunities in plain sight as well...
This is very interesting, Perry. I didn't realize that structural changes in a financial filing as compared to industy peers can merit further analysis can point to hidden risks. It seems like the amount of space devoted to discussion of certain items can be as informative as the actual data.
pbeaumont
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pbeaumont,
User Rank: Apprentice
7/18/2014 | 11:08:29 AM
Re: Opportunities in plain sight as well...
Sometimes the more interesting elements relate not so much to the particulars of content (though the evolution of financials and related specifics are certainly worth monitoring) but rather the structure of documents.  For example, how much space is a firm devoting to management discussion and analysis (MD&A), and what level of detail is being provided on current or forward looking risks relative to peer group? Also of interest is the pattern of filings, such as whether a firm is timely or late, or if a filing is subsequently amended. There is also the consideration of non-financial elements like abrupt changes in management, auditors, accounting methods, and so forth.
IvySchmerken
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IvySchmerken,
User Rank: Author
7/18/2014 | 9:24:45 AM
Re: Opportunities in plain sight as well...
Thanks for your comments, Perry. Reading the footnotes in 8k and 10k reports has proven to be very valuable. Wasn't it Enron that buried its holdings of OTC derivatives in the footnotes? But this type of granular analysis can be very time consuming and many people probably don't do it. As you point out, XBRL can help firms mine thousands of data points. What kinds of nuggets are you finding buried in these data elements?
pbeaumont
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pbeaumont,
User Rank: Apprentice
7/17/2014 | 5:44:22 PM
Opportunities in plain sight as well...
Just as Mitchel correctly states that many risks can be avoided by digitizing paper documents, there are many opportunities that can be captured with a methodical analysis of financial documentation as well.  Nearly one in five public company documents filed with the SEC are subsequently amended, and all manner of key data are embedded within footnotes, fine print, and cross-referencing resources (as with "incorporation by reference").  Our research shows there are appreciable rewards that can be achieved with a proper mining of relevant data elements, especially today when public firms are required to file information using machine readable formats (XBRL and other), which in turn facilitates the analysis of thousands of datapoints at a time.    

Perry Beaumont, Ph.D.
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