Martijn Groot, VP of Product Strategy from Asset Control
The Fundamental Review of the Trading Book (FRTB) is designed to provide institutions and regulators with an accurate risk measure of the potential impact of the worst case scenarios. But as financial institutions begin to wrestle with this upcoming regulatory demand, the challenges associated with collecting and validating ten years of history across every single instrument in order to identify the worst 2.5% of performance cannot be underestimated.
FRTB is just one component of a reinvigorated focus on historical data – but it is one that, should an organisation fail to achieve, will have significant implications on capital holdings requirements. Furthermore, this is not just a minor tweak on existing requirements: FRTB is both deep and wide-ranging and demands a substantial data infrastructure overhaul.
From identifying gaps in history, to flagging history that doesn’t qualify for use due to inaccuracy and adding external data sources and proxies, Martijn Groot, VP of Product Strategy at Asset Control insists that this renewed regulatory focus on historical time series data demands a strong information management architecture.
Value at Risk
One of the many outcomes of the 2007-2008 banking crisis was a devaluing of the Value at Risk (VaR) measure in use since the mid-1990s to evaluate an institution’s day to day risk. As the unprecedented and unpredicted events occurred, a risk probability created on a ‘business-as-usual’ basis simply did not stand up.
While the most recent regulatory focus has been on stress testing, the complete market risk evaluation is now being revisited – and with far more stringent information demands. These demands are designed to overcome the deficiencies of the VaR metric and, critically, estimate the size of potential losses in the event of unusual events, rather than putting an upper bound on losses in a business-as-usual day.
The Fundamental Review of the Trading Book (FRTB) should provide both institutions and regulators with a more accurate and trusted risk measure. However, achieving this objective will require far more than simply extending the original VaR calculations. Indeed, FRTB has thrown the VaR metric out completely – rather than looking to determine the maximum possible loss on a normal day, institutions must now calculate the Expected Shortfall (ES) on an abnormal day. Essentially, the demand now is to create a daily metric that estimates potential losses on the worst 2.5% of days for any given institution.
With regulators becoming more prescriptive and demanding less unwarranted variation between firms, FRTB is, of course, not the only legislative change refocusing activities towards historical data. However, the challenges associated with such wide-ranging data requirements may take some organisations by surprise. This shift in emphasis may sound straightforward, but drill down through the detail and the information management requirements associated with FRTB are significant and multi-layered. One of the intrinsic differences between ES and VAR calculations is that the former will be based on ten years of history, as opposed to the much shorter history required previously. It is paramount that this data is of sufficient quality and frequency to ensure there are no gaps and no inconsistencies – and it needs to be validated and audited.
In addition, FRTB distinguishes between modellable and non-modellable risk factors. Something can be modellable based on the availability of sufficient observable traded prices or non-modellable. The point here is that an organisation needs different sets of market data for the identification and calibration of these risk factors. For the determination of modellable vs non-modellable risk factors, only transaction prices can be used, whereas for the calibration thereof a wider permitted set of market data applies.
So what happens if an institution doesn’t have ten years of history for each and every aspect of the trade portfolio? If it does not have real prices? Or continuous, gap free observations? Obviously estimates can be used – but such calculations need to be audited and they must meet very specific validation requirements.
The right information management infrastructure to collect and retain this data is clearly important – but institutions will also need a way to identify gaps in the history, flag any history that doesn’t qualify for use within the risk management calculation and support the use of third party sources where required to build the complete picture.
There is no doubt that the majority of institutions will have to turn to external third party data providers, including brokers and pricing providers, to fill the gaps in their time series data. However, poor validation is one of the biggest potential issues facing organisations creating the ES metric. Without strong screening mechanisms, there is a profound risk that erroneous data could be included in the calculations. For example, if a screen has not refreshed its quotes the result will be a flat graph showing the same price for some time – something that would clearly disqualify the history from the calculations.
Another challenge will be the use of proxies. If an institution opts to use another instrument to approximate or plug a gap in the history, it will be important to record on what basis the proxy has been used, and why, in order to prove to regulators the proxy’s validity as a comparable security.
Clearly to achieve a reliable picture of the market, it will be important to combine multiple data sources – adding quotes from market makers and taking the average. The ability to combine multiple inputs, identify outliers and validate data sources is required to build up and verify this ten year history.
It is only once the complete history of returns for each instrument is in place that organisations can begin to create the ES metric. At this point, the institution must then rank returns, sorting them from low to high, and then zoom in on the tail – the 2.5% of worst cases – and determine the average associated expected loss. In addition to the challenge of scanning these histories for the most stressful period for potentially thousands of risk factors, institutions will need to take into account different periods, ranging from ten to sixty days, depending on the liquidity horizon of the instrument.
Speed is essential. The ability to focus quickly on the worst 2.5% of returns for each risk factor is key – and demands an institution can scan and identify these thousands of risks on a daily basis. The immediate challenge, however, is to get that data infrastructure in place. Collecting, identifying gaps, introducing new sources, validating ten years of history across every single risk factor and quickly identifying the most turbulent periods for each time series will be a major project.
While FRTB will soon become a regulatory requirement, there are benefits to organisations over and above compliance. Firstly, this in-depth, accurate and validated data source can become the base upon which market shock/stress tests are applied – delivering another aspect of the regulatory demands in the US and Europe.
However, over and above any regulatory compliance, there are significant financial implications associated with FRTB. Any bank that fails to achieve the ES calculation with a validated risk and information infrastructure will lose the right to use its own internal models to run risk and will be forced to use the far coarser standard models from the regulators. The result will be a demand for far higher capital holdings – as much as five times higher according to some estimates. Essentially, get FRTB right and banks will be in a position to make more efficient use of their capital, which is a clear commercial benefit beyond regulatory compliance.
This is a major shift in both mind-set and technology – and the sooner organisations embrace a new, robust data management architecture, the better.
Dollar extends decline as risk appetite favors equities
By Stephen Culp
NEW YORK (Reuters) – The dollar lost ground on Friday, extending Thursday’s decline as improved risk appetite attracted buyers to equities and away from the safe-haven greenback.
The U.S. dollar has been weighed down by a string of soft labor market data, even as President Joe Biden’s proposed $1.9 trillion spending package takes shape.
“What the foreign exchange market is looking at in the short term, is the dollar is going to be weak despite progress in the economy because this country has a huge deficit problem,” said Peter Cardillo, chief market economist at Spartan Capital Securities in New York. “The dollar index could easily test the lows of last September.”
Also weighing on the dollar, the real yield gap between the United States and Germany is at its tightest since March, analysts said, despite the recent rise in U.S. Treasury yields.
Bitcoin continues to hover at record highs, and the world’s largest cryptocurrency was last up 2.6% at $52,931.46, nearing $1 trillion in market capitalization.
Its smaller rival, ethereum, was last down 1.0% at $1,920.13.
The digital currencies have gained about 82% and 1,400%, respectively, year to date, leading some analysts to warn of a speculative bubble.
“There may be a place for (cryptocurrencies) somewhere down the road, but the theories that cryptos will replace paper currency are far-fetched,” Cardillo added. “It’s total speculation at this point and people are going to pay the price.”
The Australian dollar, which is closely linked to commodity prices and the outlook for global growth, was last up 1.15% at $0.7858, touching its highest since March 2018.
The New Zealand dollar also gained, closing in on a more than two-year high, and the Canadian dollar advanced as well.
Sterling rose to an almost three-year high amid Britain’s aggressive vaccination programme. It had last gained 0.34% to $1.40.
The euro showed little reaction to a slowdown in factory activity indicated by purchasing manager index data, rising 0.29% to $1.2126.
The yen, gained ground against the dollar and was last at 105.495, creeping above its 200-day moving average for the first time in three days.
(Reporting by Stephen Culp, additonal reporting by Tommy Wilkes; editing by Emelia Sithole-Matarise)
Bitcoin hits $1 trillion market cap, soars to another record high
By Gertrude Chavez-Dreyfuss and Tom Wilson
NEW YORK/LONDON (Reuters) – Bitcoin touched a market capitalization of $1 trillion as it hit yet another record high on Friday, countering analyst warnings that it is an “economic side show” and a poor hedge against a fall in stock prices.
The world’s most popular cryptocurrency jumped to an all-time high above $54,000, setting it on course for a weekly jump of more than 11%. It has surged roughly 64% so far this month and was last up 5.5% at $54,405.
Bitcoin’s gains have been fueled by signs it is gaining acceptance among mainstream investors and companies, from Tesla and Mastercard to BNY Mellon.
All digital coins combined have a market cap of around $1.7 trillion.
“If you really believe there’s a store of value in bitcoin, then there’s still a lot of upside,” said John Wu, president of AVA Labs, an open-source platform for creating financial applications using blockchain technology.
“If you look at gold, it has a market cap $9 or $10 trillion. Even if bitcoin gets to half of gold’s market cap, that still growth of 4X, or $200,000. So I don’t know when it stops rising,” he added.
Still, many analysts and investors remain skeptical of the patchily regulated and highly volatile digital asset, which is little used for commerce.
Analysts at JP Morgan said bitcoin’s current prices were well above estimates of fair value. Mainstream adoption increases bitcoin’s correlation with cyclical assets, which rise and fall with economic changes, in turn reducing benefits of diversifying into crypto, the investment bank said in a memo.
“Crypto assets continue to rank as the poorest hedge for major drawdowns in equities, with questionable diversification benefits at prices so far above production costs, while correlations with cyclical assets are rising as crypto ownership is mainstreamed,” JP Morgan said.
Bitcoin is an “economic side show,” it added, calling innovation in financial technology and the growth of digital platforms into credit and payments “the real financial transformational story of the COVID-19 era.”
Other investors this week said bitcoin’s volatility presents a hurdle for it to become a widespread means of payment.
On Thursday, Tesla boss Elon Musk – whose tweets have fueled bitcoin’s rally – said owning the digital coin was only a little better than holding cash. He also defended Tesla’s recent purchase of $1.5 billion of bitcoin, which ignited mainstream interest in the digital currency.
Bitcoin proponents argue the cryptocurrency is “digital gold” that can hedge against the risk of inflation sparked by massive central bank and government stimulus packages designed to counter COVID-19.
Yet bitcoin would need to rise to $146,000 in the long-term for its market cap to equal the total private-sector investment in gold via exchange-traded funds or bars and coins, according to JP Morgan.
Rival cryptocurrency ether traded down 0.3%, at $1,934.67, still near a record of $1,951 reached earlier on Friday. It has been lifted by growing institutional interest, after its futures were launched on the Chicago Mercantile Exchange.
(Reporting by Gertrude Chavez-Dreyfuss in New York and Tom Wilson in London; Editing by Dan Grebler)
UK retail sales drop, NatWest loss dampen FTSE 100 mood
By Shivani Kumaresan and Amal S
(Reuters) – The FTSE 100 was muted on Friday as a bigger-than-expected drop in January retail sales underscored the business damage from a prolonged nationwide lockdown, while NatWest group fell after swinging to an annual loss.
The commodity-heavy FTSE 100 was flat as gains in miners Anglo American, Rio Tinto and BHP Group capped losses.
Oil producers BP and Royal Dutch Shell fell 1.2% and 0.5%, respectively as crude prices slid.
Data on Friday showed British retail sales tumbled much more than expected in January as non-essential shops went back into coronavirus lockdowns. Flash readings of business activity data, due at 0930 GMT, are likely to show the services sector struggling to return to growth in February.
“The 8.2% fall was considerably higher than we’d expected (around 4%), and provides clear evidence the hit to consumer spending is noticeably larger than it was during the November restrictions,” said James Smith, market economist at ING.
He added focus will now be on UK’s COVID-19 vaccination program and easing of restrictions, to drive economic recovery.
The FTSE 100 has recovered nearly 35% from its March 2020 lows but has been largely range-bound since the beginning of this year as a nationwide lockdown hurt business activity, undermining hopes of economic growth in the second half of the year.
The domestically-focused mid-cap FTSE 250 index rose 0.2%, with consumer and industrials stocks leading gains.
NatWest fell 0.6% after the financial services provider swung to a full-year loss for 2020 after COVID-19 lockdowns crunched household spending.
Segro Plc rose 1.7% after the real estate investment trust reported a near 11% jump in annual profit for 2020.
Banking group TBC Bank fell 2.3% after a slump in annual underlying profit due to lower interest rates and limited lending growth in the fourth quarter from the COVID-19 pandemic.
(Reporting by Shivani Kumaresan and Amal S in Bengaluru; Editing by Vinay Dwivedi and Krishna Chandra Eluri)
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