The Rise of Financial Risk Management
A Cautionary Tale
It was April 20th, 2015. I was acting investment director for two offshore commodity-focused hedge funds, preparing an agenda for a weekly conference call when I received a short and hastily written email from one of my directors. It urged me to read an article from The Economist Magazine aptly titled "Trouble in Paradise". (April 18th, 2015, The Economist)
The piece referred to allegations of fraud - not the first time an offshore fund administrator had been accused of running afoul of regulators - but this story was notable for a couple of reasons. First, for the sheer scale of the allegations, spanning multiple jurisdictions and implicating a hundred loosely connected funds with a total reported net asset value in excess of $16 billion. And second, our offshore administrator had been named in the investigation - sweeping our two commodity funds into the dustbin of a multi-jurisdictional investigation.
While the article itself offered little in the way of substantiated claims, there was enough smoke, enough intimation of Ponzi schemes, and one suspects enough concern for investor protection (if not professional liability), to turn up the regulatory heat.
Our two funds represented a small amount of the reported $16 billion in question and because we invested exclusively in equities and unit trusts, our accounting was a simple mark-to-market exercise. We expected that the timely appointment of a new administrator and a summary audit would remove the cease-trade orders on our funds and return us to business as usual. But as days turned to weeks, and then months, the enormity of the real problem surfaced.
Faced with the challenge of scrutinizing a vast web of segregated funds and asset classes across multiple jurisdictions, and unraveling thousands of transactions for conflicts and irregularities, the regulators responded in the only way they could. They froze.
Capital In the New World
The speed, mobility, and innovation of capital markets in the 21st century is forcing financial institutions and their administrators to re-think how they do business - and not just those in sunny island jurisdictions.
On the heels of the 2008 financial crisis, with attention squarely on the banks and the massive bailouts they commanded, a chorus of accusations rose from New York to London. How could financial regulators be so lax? How could compliance departments be so permissive? How could rating agencies be so complicit?
The simple fact is that the risk models the banks and their regulators rely on are hopelessly outmoded, shackled to a banking orthodoxy that favors secrecy and departmental "church and state" separation. At almost any cost.
Enterprise Risk Management (NYSEARCA:ERM) has emerged as the industry's best shot at a remedy. As the name implies, ERM applies a broad-based approach to risk. Where accounting standards like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) give a valuable, if limited, quantitative view of risk exposure, ERM offers a much more nuanced, qualitative, and informed view.
By removing the informational silos of front-office, operations, and compliance, items like conflicts of interest or remuneration irregularities contextualize transactional review, improving an institution's ability to pre-empt bad decision and elevate good ones.
As financial institutions and their regulators work together to build new codes of conduct, international standards by the Basel Committee on Banking Supervision (BCBS) are providing a framework for inter-jurisdictional cooperation with a comprehensive set of updated prescriptions. Central to this is the concept of Capital Adequacy, which, unlike simple leverage limits, defines enterprise-wide, risk-weighted measures of financial exposure. With 28 member nations, including all G20 countries, chief risk officers who struggled to apply risk management principles across departments can now apply them not just enterprise-wide, but globally across jurisdictions.
The business of bringing banks into 21st century standards of data integration, cooperation and compliance has created a multi-billion-dollar opportunity - one that the FinTech community is just waking up to. While companies like Moody's (NYSE:MCO) and IBM (NYSE:IBM) dominate the field with armies of sales and IT consultants, a small and largely unknown company called BlackIce (BIS) is threatening to disrupt the small-to-medium size space, mopping up business in emerging markets like Vietnam with modern enterprise software and cloud-based services.
Lessons Hard Learned
Four years before receiving that fateful email, I had been invited to give the keynote speech at a meeting of The Economist Intelligence Unit in Manila. In the Q&A following my presentation a hand was raised for the final question. "What is the most significant threat to investors in the commodities sector?" I recall giving some variation of artificial demand-side pressure, Chinese policy uncertainty, and the threat of near-term price reversals. In hindsight, I would answer that question very differently today.
As the name BlackIce captures perfectly, it's the threat you don't see coming that poses the greatest danger. The slippery surface that sent us unceremoniously into the ditch of a lengthy and punitive cease-trade order was unrelated to politics or markets. A wider, enterprise-wide assessment would no doubt have identified counter-party risk as a key data point and likely tipped the scale in favor of more preemptive and protective measures.
The rise of financial risk management is finally giving risk officers their much-deserved day in the sun. And when ERM companies begin entering the deal rooms of hedge funds and VCs, they promise to do more than serve an essential market need. They will transform risk, and the threat of a paradise lost, into something altogether more appealing. An opportunity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.