Blog Post |
Central Risk Book: Short History, Long Future.
Fragmented risk management can break a bank.
One of the reasons for Bear Stearns’ collapse after the 2008 financial crisis was its struggle to see and manage risk across geographies, asset classes, and desks. In contrast, Goldman Sachs was one of the first banks to deploy the concept of the central risk desk and minimized losses during this challenging time. Most leading capital markets firms have since followed suit and built a central risk book.
Introducing the central risk book
A central risk desk aggregates trading positions across geographies, lines of business, and desks. It constrains the trading discretion of position traders by making trading decisions based on the marginal risk of new client positions.
Regulators helped create the central risk desk
After the global financial banking crisis of 2007-2008, international regulators reviewed banks’ practices and published their risk management lessons. The report enumerated multiple deficiencies. They included excessively high leverage, an inability to measure the liquidity risk of large positions or forecast secured funding reductions, and insufficient senior risk management oversight, among other issues.
As a result of this assessment, global regulators sought to implement mechanisms to boost trading transparency and liquidity, while enforcing sound risk management practices. Multiple regulations and banking requirements followed. Chief among them are Dodd-Frank’s Living Will, requirements for stress testing of trading practices and holding more liquidity, and Basel III, among others.
Also, critically, The Volcker Rule came into effect. This rule prohibits banks from using their own capital for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments. Many proprietary traders migrated to hedge funds as a result.
Taking an enterprise view of trades and risks – and satisfying regulators – is simplified with a central risk book.
Why your bank needs a central risk book
A modern, well-designed central risk desk offers banks multiple benefits. We highlight them below.
- Create an enterprise view of risks: Before 2008, banks often lacked a centralized view of risks, which restricted their ability to offset trades and risks at a bank level. As regulators pointed out, this lack of transparency left capital markets firms vulnerable to compounding market stresses. As an example, in 2007, when the leveraged loan market collapsed, commercial paper liquidity evaporated, and subprime mortgages plummeted.
With a central risk book, capital markets firms can see and view manage risks across the bank in real time. With data and real-time analytics, central risk desk traders can continually fine-tune their banks’ risk position and reduce the risk of large trading losses. In addition, a central risk book enables banks to take new positions based on their changing analysis of market color.
- Enable risk-based pricing: When traders accept orders from new or existing clients, they can immediately determine the risk profile of that order and whether it increases or decreases the bank’s overall risk position. That enables central risk book traders to take specific steps to offset risks.
For example, traders can accept these orders as-is, provide discounts, decline trades, or offer higher risk-based pricing that offsets the bank’s risk. This enables banks to accept a wider range of trades without incurring unwanted risks.
- Lower trading costs: An effective central risk book can lower trading costs in three ways:
- More internalization. A central risk book can use trade flows to forecast trades for internalization, which saves the need to pay away bid-ask spreads.
- Competitive pricing for clients. Pricing based on marginal risk contributions means that central risk desks can offer bank clients more competitive pricing and better executions.
- Lower capital. Aggregating risks across desks can result in using less regulatory and economic capital. In addition, it can save funding charges from internal treasury departments.
- Prevent proprietary trading: The Volker Rule, which was passed by multiple regulatory agencies, shut down proprietary trading as of April 1, 2014 for large banks with active trading desks. However, certain activities, including hedging, are exempt. That means that traders of the CRB can use critical insights from market color to hedge risks. However, banks must take care not to use insider information. So, the ability to use statistics on data, rather than the data itself, can enable central risk book traders to hedge risks in a secure, compliant manner.
Central risk book: Reinvented
Now, leading banks are reinventing their central risk books. Using LeapYear’s privacy-enhancing technology, they can generate more market color from sensitive data and flow trading. This means central risk desks see more of their banks’ trades, flows, and positions, which makes the central risk book even more valuable.
In addition, using LeapYear’s privacy-enhancing technology gives banks the power to assure clients and regulators with provable privacy protection. This clears away the historical controversies around central risk desks and proprietary trading.
Read our white paper to see how LeapYear is enabling a top-10 market maker’s CRB to unlock the value of agency flows trading, increase the accuracy of its trading-flow forecasts, and provide quantified privacy protection to its agency clients.