Why firms must consider dynamic risk management

Key Takeaways

• New regulation adds more risk-management requirements in derivatives
• High-quality and real-time data are central to supporting efforts
• Dynamic risk management requires collaboration, integrated systems

The world’s largest banks have long been up in arms over sweeping regulatory reforms in the US that – if successful – would see them forced to hold much larger capital reserves to support ‘riskier’ banking activities.

In May this year, the International Settlements and Derivatives Association (ISDA) described the impact of the proposed Basel III Endgame regime as presenting a “significant negative impact on trading activity and the liquidity and vibrancy of the US capital markets, with adverse effects on derivatives end users, investors, businesses and consumers”.

Indeed, the proposals – revealed last July – have come under such attack that Federal Reserve Chairman Jerome Powell told Congress this March that some of the reforms would be scaled back.

However, even under a watered-down regime, banks with more than USD 100 billion in assets are already grappling with volatile markets and liquidity challenges and will need to focus more than ever on dynamic risk management strategies.

And it’s not just the largest institutions that need to consider the importance of dynamic risk management; all firms engaged in trading and hedging activities need effective processes to ensure the best execution.

The upcoming Fundamental Review of the Trading Book also requires banks to make a more rigorous assessment of their market risk exposure. This includes new eligibility tests for risk factors used to derive capital requirements under a revised Internal Model Approach. With changing deadlines for compliance and varying local interpretations, firms continue to struggle with the complexity of the guidelines under fluctuating budgets.

Efficient risk management provides the essential foundations for anticipating, measuring, and mitigating risks in today’s volatile and complex market environment. By doing so, it enhances strategic decision-making, ensures regulatory compliance, and ultimately contributes to the firm’s stability and profitability.

Fortunately, major technological advances are making dynamic risk management easier and more effective than ever before.

Volatile markets

Volatile markets are a recurring feature of the modern financial landscape, driven by geopolitical tensions, technological disruptions, and macroeconomic shifts.

Firms need to be able to protect against market fluctuations but also capitalise on the potential opportunities available.

Effective risk management in volatile markets demands a combination of strategic foresight, adaptability, and proactive decision-making. Real-time insights into risk exposure allow for better-informed decision-making, and traders and risk managers can make adjustments based on current market conditions rather than relying on outdated information.

Stress testing and scenario analysis are central to risk management strategies in volatile markets. Traders must anticipate and understand the potential impact of significant market movements, black-swan events, or sudden economic shifts.

Traditional risk systems that rely on legacy technology may lack the ability to provide a comprehensive historical lookback and create risk profiles, leaving traders vulnerable to unforeseen risks.

High-frequency data

High-quality and real-time data are critical to delivering effective risk management, and today’s derivatives traders have access to huge volumes of information for more granular trading insights. Monitoring market moves by viewing aggregate trade information for previously settled, pending, and intraday trades has led to improved analysis that can be produced by cumulatively seeing the totals for all loans and loan returns throughout the trading day.

This increases transparency into intraday borrow costs, which, as we saw during the US regional banking crisis in March 2023, can change at an ever- increasingly rapid pace.

High-frequency data is also essential in providing the next generation of products and solutions, which market participants require to continually improve multiple aspects of their day-to-day processes.

Integrated systems

Disparate and outdated technology and processes hinder effective risk management, and firms are increasingly looking to integrate and upgrade existing systems.

Opting for a single platform to manage market, counterparty credit and liquidity risk, and offering enhanced stress testing can help firms stay on the right side of the regulator while managing costs and improving efficiency.

Further, integrated systems are scalable, allowing firms to easily expand their risk management capabilities as their business grows, and they offer flexibility to adapt to new products, markets, and regulatory changes without requiring significant overhauls.

Real-time challenges

Derivatives traders have long been used to real-time cash, collateral, and liquidity demands. However, there are still significant challenges to overcome in delivering real-time risk management, including a lack of standardised definition of real-time liquidity, inconsistency between banks in the analysis and management of real-time liquidity, and obstacles posed by legacy technology infrastructure.

To ensure dynamic risk management, greater collaboration across the industry, including sharing expertise and presenting a single voice to regulators, is required. Firms also need to explore technology solutions to analyse and manage liquidity, and we are seeing some efforts here.

For example, the number of banks that provide a dedicated suite of corporate API offerings has significantly increased, leading to a situation in which firms can now consume real-time balances across multiple bank partners and time zones, enabling a truly comprehensive view and management of liquidity.

Significant strides have been made in dynamic risk management, but more needs to be done. Greater use of technology—specifically AI—will help overcome some of the existing challenges, but institutions and regulators will need to work together to ensure optimum technology and processes are in place to support the next generation of risk management.