Risk Management: A Critical Imperative for Financial Institutions

Open-source solutions have revolutionized various aspects of technology, from the Linux operating system to cutting-edge AI models. However, one area where financial institutions have been slower to adopt open-source solutions is risk management. For smaller financial institutions, which often struggle with the high costs and complexity of in-house or vendor-provided risk management systems, open-source platforms offer a compelling alternative.

One such platform is the Open-Source Risk Engine (ORE), available on GitHub. ORE is built on top of QuantLib, a widely respected open-source pricing and risk library that has been in use since 2000. Both platforms are written in C++, which ensures high performance and efficiency. However, they require technical expertise to install, build, and maintain, meaning that while these solutions are accessible to smaller institutions, they still require a significant commitment of resources to implement and operate effectively.

The recent turmoil in global markets—highlighted by the unexpected reaction to the U.S. employment report, coupled with the shock of the yen revaluation and the unwinding of yen carry trades—underscores the vital importance of robust risk management for financial institutions.

At the heart of modern risk management is the concept of Value at Risk (VaR). VaR estimates the potential loss an institution could face over a one-day or ten-day period under normal and stressed market conditions. It involves analyzing historical data, often spanning at least five years, to identify extreme market movements—typically two or three standard deviation events—and applying these scenarios to current positions to estimate potential losses using variance-covariance or Monte Carlo techniques.

For example, the recent movement in USD/JPY was significant, but not unprecedented. Similar moves occurred in the fall of 2022 when USD/JPY dropped from 150 to around 128—a much larger decline. The key difference was the market environment: in 2022, Japanese interest rates were falling and US rates were rising, whereas the recent move was triggered by a rate hike from the Japanese Ministry of Finance, coupled with a decline in U.S. rates. These factors combined to make the yen carry trade—borrowing JPY to invest in USD bonds—a losing proposition. A well-calculated VaR should have anticipated this risk, allowing institutions to withstand the impact.

Another challenging area of risk management is derivative counterparty risk. While an institution can manage its own VaR, it may not fully understand the risks posed by its counterparties. A notable example is the collapse of Archegos Capital Management, which used Total Return Swaps with multiple counterparties to mask its exposure to ViacomCBS. Without visibility into Archegos’ total exposure, counterparties were caught off guard. However, with effective counterparty risk management, firms could have used Potential Future Exposure (PFE) calculations to assess and mitigate the risk of a counterparty defaulting when it is deeply out-of-the-money on a derivatives contract.

PFE calculations are complex, typically involving Monte Carlo simulations to assess the potential movements in the value of derivatives under various scenarios. These calculations require:

• Accurate pricing of the derivative contract at future points on the forward curve.
• Scenario analysis using historical volatility data to simulate potential outcomes.
• Credit risk assessment of the counterparty, including metrics like credit ratings and potential loss given default.

While daunting, these calculations are essential and often mandated by regulators. Many institutions rely on external vendors like RiskMetrics, Numerix, Bloomberg, or S&P for these models. However, the ORE Engine offers an in-house alternative, albeit one that requires significant IT and risk management expertise to set up, run, and maintain. The advantage of using ORE lies in the potential for cost savings and greater control over the development and customization of the system, which can be invaluable over time.

In conclusion, it is imperative that financial institutions invest in robust risk management systems. The future is uncertain, and no one can predict what challenges lie ahead. However, with a strong risk management framework and a culture that prioritizes vigilance, institutions can fortify themselves against the unknown, ensuring they are well-prepared for whatever comes next.