The fast moving world of risk management

Imagine a jet fighter so inherently unstable that it needs the super fast brain power of a computer to fly it. Increasingly that is the role that Risk systems are playing on modern trading floors.

Without their advanced software today’s high speed trading systems risking crashing and burning at the hands of their all too human operatives. Organisations that fail to install these systems are finding themselves in a Darwinian race for survival against the more sophisticated operators who already have. The price the laggards will pay is extinction and the early signs are that it is already happening, even as I write.

Actually we don’t have to imagine that unstable jetfighter; they are already being built and any superpower who takes its technology seriously knows they need them to win a battle in the air. It’s the same with Risk systems. Superior banks intent on delivering superior profits have either built their own systems or bought a state-of-the-art system more than a decade ago and the advantages it gives them in today’s market are becoming increasingly clear

Statistics show us that top tier banks are making more money from their trading operations than ever before – even though in many case the actual number of individual days in which they show a trading loss is actually going up, not down. How do they do this?

They are using their sophisticated risk systems to allow themselves to take on more risk but in a way that is controlled and ultimately profitable. This attribute is now setting them apart from their weaker competitors – who metaphorically are trying to fly the same “jet fighter” but without the same state-of-the-art controls.

So what are these risk systems and how did we get to this Darwinian turning point? In fact it was sheer survival instinct that gave birth to risk products in the first place. In the early days the speed with which banks learnt was governed by their proximity to potential near-death experiences – and some learnt very quickly indeed.

The Nick Leeson affair and the collapse of Barings Bank was one of the early spurs to action. Every bank in the world looked at the fallout and said ‘how can we build in controls that ensure this never happens to us?’ After that large institutions bought – or just as often – developed risk software because they wanted to understand the potential effects risks that they were taking

These first-generation risk systems were capable of answering the historical question: ‘why did we lose all that money last week?’ That in itself was incredibly valuable but compared to today, the markets in the nineties were only going at 20 miles an hour so at that comparatively leisurely pace there was time to learn from the experience. If you didn’t you wouldn’t be around for much longer.

Today’s risk systems have taken this a step further. Where once they simply gave a glimpse into a the rear view mirror at what had happened, now they illuminate the road ahead - allowing traders to move much faster whilst avoiding potential disasters.

As the pace the markets move at has accelerated from 20 to a 100 miles per hour there is no time for leisurely retrospection, analysis of what is going wrong needs to be instant and in real time. One result of this is that traders can now take a deal and, rather than just doing it and hoping for the best, they can use a pre-trade analytic to see how their portfolio changes shape, allowing them to ask themselves if that is a picture they like the look of.

In fact these systems go further than that by acting as an institutional memory and actually setting boundaries around what individual traders can do. Just as the jet fighter’s computer will not allow the pilot to crash the plane an effective risk system can stop a rogue trader bringing down the bank.

Because of this the trader himself is changing. He is no longer the lone warrior he used to be in the past where everything was based on his own view of the world. That view is now largely provided to him by his trade and risk system and he is expected to operate within that domain. More and more decisions are being made less from the gut but from based on sophisticated analysis and tightness of the fit with the whole organisation’s strategy

Where once a he could look at a deal and say this is a really good transaction, the reality might be that in the context of what is happening throughout the entire firm it could be disastrous. That’s where a risk system will step in, and warn him. In this environment the traders act as a team or a unit almost whether they want to or not whilst the risk system keeps them within individual pre-defined boundaries.

The largest, most sophisticated and, perhaps not coincidentally, profitable financial organisations use these attributers of risk systems to effectively enforce the bank’s global trading view across all parts of the organisation. In this way the sophisticated pricing models drawn up by the institutions mathematical elite can be spread effectively to everyone. Like a bookmaker adept at calculating the odds the whole organisation, not just select parts of it, can participate in a consistent market view where the bets can be both big and profitable.

So much for the big players – but what about the mid tier banks? The good news for them is that today they can buy the risk systems that were once only the preserve of super rich institutions. This is good news for those who have not yet got these systems, as the hand of Darwinian selection is about to reach out and give them a nasty shock.

In the 100-mile-an-hour market I have described how the banks with superior risk systems are cruising comfortably on a well lit road - but for their weaker competitors the ride is a rough one indeed. Their noses are pressed up again the windscreen looking out on a darkened landscape. By rights they should be crawling along at walking pace, but of course they too must travel at a 100 miles an hour to stay in the race. It’s just a matter of time before an unexpected bend leaves them upside down in a ditch with their business in tatters.

The stark message is that enhanced risk management will leave the strong better placed to survive and able to reap greater rewards, whilst the weak will continue to take breathtaking risks on their unlit journey