Don’t rely only on SEC systemic risk disclosures to keep you from blowing up

February 22, 2012  

Regulators might think it’s important to place reliance on VaR, but that doesn’t necessarily mean you should. There are more effective ways to safeguard your firm.

   Lynn Connolly
By Lynn Connolly

In trying to be helpful, regulators could be giving you a false sense of security about your market risk management. Remaining with traditional metrics and measurements is not enough to understand how to mitigate market risks in today’s volatile environment, and new regulatory and industry requirements that call only for high-level, basic, summarized risk reports dropped down from 30,000 feet provide a dangerous sense of security without pointing out real risks.

In the SEC’s recently-released—and hotly discussed—Form PF[1] (a new SEC reporting rule to assist in monitoring systemic risk ), the risk metrics section encompasses several pages of requests that may not get one any closer to fully understanding where systemic risks are and how to mitigate them in your portfolio. One page alone is completely related to VaR, yet for certain portfolios, that measurement is either not relevant or is only useful as a starting point to uncover the where real risks to the portfolio lie.

The remainder of the form is not reflective of current best practices. There are questions regarding the effects of single, not multiple, factor stress tests on the portfolios, including several scenarios that do not reflect realistic global market moves. For instance, the fund is asked to consider the impact of changes in currency rates where all currencies move up or down by a specified amount relative to the fund’s base currency, which in most cases is the U.S. dollar; or where prices of all physical commodity move in the same direction by plus or minus a set percent, which are both absurdly low-probability events.

While it’s noble that the SEC and other regulators have attempted to devise catch-all disclosures that will aid firms in avoiding cataclysmic risks, there is a much more effective way to ensure that your internal market risk platform provides a realistic safeguard.

While formulaic disclosures of risk threaten to oversimplify our analyses, ever-expanding computing power and quantitative methodologies are now being effectively combined with common-sense qualitative analysis to gauge risks and opportunities. In re-thinking what risk factors we should be examining, some have suggested that managers employ behavioral finance measurements and quantification of news reports as means of determining market sentiment. Some recent systems, when combining these approaches, have demonstrated particularly interesting and insightful results in correlations, trends, peer groupings, etc. which are directly applicable to market risk management.

Regardless of what information is gathered, it cannot be chosen or thrown together at random. While managers need their risk management systems to reflect reality, all too often internal risk management models are built without input from the traders, portfolio managers, brokers and analysts who drive the day-to-day trading and portfolio decisions. Many funds use elegant systems that miss some of the nuances and nature of the markets.

A more straightforward way to proceed is for the portfolio managers and traders to collaborate with the risk managers. Although much has been made about segregation of duties, this does not mean to not communicate. Anyone on the front lines with an understanding of the markets knows where the greatest risks and potential profits may be, and risk managers know about the latest developments in order to measure, monitor and substantiate these instincts. There should also be a risk system interface situated on the front lines displaying meaningful intraday metrics in addition to the traditional risk systems running in the risk management department. Everyone should be able, at a glance, to quickly understand the current risks and potential actions to be taken.

Essentially, market risk needs to reflect the reality of the markets and your portfolio. Not relying only on the requirements of recent regulations or the traditional metrics of the past, will be crucial in the future. There is real money at stake!

Lynn Connolly is director of risk management advisory at Constellation Investment Consulting Corp., a New York firm that provides external market risk, regulatory and compliance services to hedge funds.

[1]Form PF is a reporting form for investment advisors to private funds and certain commodity pool operators and commodity trading advisors.

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