0. How are the responsibilities of derivative traders changing in line with methodological advances?
Business Resources Management
Paul Shah
2 Sep 2013

1. Inventory and portfolio trading
Analogy with CVA, and where it breaks
The role of the portfolio trading desk
A case study : a trading model of rate swaps
Using technology
Conclusions

2. Inventory and portfolio trading
Traditional business management structures to adapt to meet resource constraint challenges
Trading floors oriented to inventory trading within defined asset class management lines
Hierarchy problem : translation of portfolio resource constraints to asset, business, inventory resource constraints
Standalone, marginal, incremental approach to splitting portfolio risks?
Standalone robust, but neglects to incentivise macro risk offsets
Marginal and incremental useful for management actions but project assumptions on current state to future
Reorganise risks and management structure into Inventory (Micro) and Portfolio (Macro)
Inventory traders
Make markets and manage inventory market risks
Are given standard contract assumptions (eg SCSA+)
Execute hedges on behalf of Portfolio traders
Receive allocations of Portfolio costs net of those hedges
Portfolio traders
Assume risks that cannot be discretised to trade level
May also assume certain trade level risks that funge across asset classes (eg non-standard collateral risks)
Receive portfolio funding costs allocations from Treasury
Execute portfolio hedges, buffering winner/loser effect at the Inventory level
Provide portfolio cost allocations and incentive models to Inventory traders 2

3. Analogy with CVA, and where it breaks
CVA desks as the original Macro desks
Portfolio valuation methods analagous to VAR calculation set up to net risks across asset classes
CVA traders price trades to net increase/decrease in portfolio cost, hedge embedded greeks
Low frequency assumption : netting set does not evolve in realtime
Persistence assumption : costs presumed to exist until final maturity of transaction
Computational assumption : portfolio tractable to point-of-trade computation
Examples of other portfolio costs
CCP Initial Margin
CSA Thresholds
2notch downgrade
Collateral outflow in stressed market
Intraday liquidity reserve
CCP Initial Margin fails the low frequency and persistence assumption
CSA Thresholds fails the computational assumption
etc
Portfolio risk manager needs to design new techniques for pricing and risk
Incentive models (for example, risk accepted within tolerance, pricing fee/benefit for liquidity risk outside tolerance)
Level at which control risk and allocate incentive models (business, trading desk, trader) 3

4. Resource Management Desk
Model Trading Floor
Desk A
Unfunded inventory
Funded inventory reserve (stress haircuts, rollover)
Loans
Derivative VM
Initial Margin on Exchange/CCP
CVA
Derivative Working Capital (Thresholds, CIT, Net IA deposits)
2-Notch Downgrade Provision
Collateral Outflow in Market Stress
Nostro Pre-Funding Provision
Other buffers
Debt Buy-backs
Debt maturing during scenario window
Desk A
Book A,B,C
Inventory
Risk managed and transfer priced at trade level
Derivative funding discount risk could be managed either at trade level or risk stripped to a central book
Business unit net cost allocations
Transfer Pricing
and
Usage Reporting
Resource Management Desk
Portfolio
Hedging to the Street
Financing
bake into funding rate 4

5. The role of the portfolio trading desk
Portfolio desk acts as a buffer between Corporate Treasury and trading desks
Choice of models to implement funding cost transfer
“Bake into rate” : take cost of liquidity reserves and adjust business funding rate : Pros : simple to implement. Cons : charges the wrong trades, distorts trading incentives
“Actual cost” : realised cost of unsecured funding and liquidity reserves split by allocation methodology across desks. Pros : transparency to actual usage drivers. Cons : complicated methodology to implement, point of trade assessments tricky
“Incentives model” : model designed to discourage behaviour risk-additive beyond some tolerance. Pros : human pilot, implementation can be easier. Cons : could seem arbitrary (eg “ageing cost”).
Inventory risk
Add haircut unsecured funding cost, repo rollover risk, haircut widening risk to produce blended all-in asset funding cost by inventory category
Secured funding desk to manage residual risk (realised spread to blended) and concentration targets
Derivative discount risk funges across product, so more efficient to implement a risk-stripping methodology
Traders price to CSA discount model
PV split into SCSA and “Collateral switch” piece
Collateral switch risk stripped to central FVA book, who receive actual collateral balance and provide synthetic balance to desk
FVA book manages CSA decisions and portfolio trading decisions (bulk clearing) etc 5

6. The role of the portfolio trading desk, cont…
Resource management desk acts as a buffer between Corporate Treasury and trading desks
Portfolio risk
Collateral outflow in market stress
Can be implemented by a new blended CVA charge/rebate, managed by CVA desk
Incentivise risk reduction trades to offset current portfolio outflows
Derivative working capital : CCP Margin, thresholds, 2notch
Technologically feasible to price CCP margin at point of trade
Portfolio vol question
Franchise supportive?
Incentive model :
“Risk accepted” provided CCP Margin stays within certain bounds
Implement risk management strategies (portfolio trades, ccp switches) and incremental charges for risk-additive trades administered by FVA desk
Allocation of CCP margin cost net of risk mitigation provided to business divisions
CSA negotiation, assigns, tearups pnl buffered by FVA desk
Winner/loser effect per trade netted out
Allocation of net residual cost benefit either buffered centrally or allocated contra-revenue
Tradeoff on accruals pnl vs realised pnl 6

7. Case study : an FVA model for OTC Derivs
Portfolio desk
manages embedded risks in collateral switch and high threshold pv
implements charge/rebate model for CCP IM, LCR costs to incentivise staying within desired risk tolerance
facilitates compression/clearing/csa negotiations buffering trading desk pv
Counterparty1
Counterparty2
Colt Mgmt Desk
Treasury Desk
Collateral received
CCP Margin funding cost
CSA threshold funding cost
Non-seg OTC IM benefit
LCR costs (eg 2notch, collateral outflow)
Desk 1
Desk 2
FVA Desk
SCSA collateral
Collateral switch pv
High threshold pv
CCP IM fee model
LCR fee model
CCP1
CCP2 VM IM
Default fund
Collateral switch pv = trade pv difference to between actual and standard collateral pv
High threshold pv = reserve cost on funding asymettric CSAs above some threshold
CCP IM fee model = rebate for risk reduction, charge for increase beyond tolerance, duration assumption
FVA Desk sets budget based on expected under/over recovery
difference in actual and priced unsec exposure
difference in priced rate and Treasury rate
CCP and LCR fee model vs actual costs 7

8. Autofee process for VM runs on EOD curves, CSA curves marked by FVA
Using technology
Trading Desk pays fee of $1 to FVA desk for IM
Trading Desk pays fee of $10-$7 to FVA desk for VM
$10
-$3 $7
Trading Desk
FVA Desk
Client Val
Risk Manage: Actual – Standard CSA
Price to clients: Actual CSA
Risk Manage: Standard CSA
Net position: Actual CSA
Autofee process for VM runs on EOD curves, CSA curves marked by FVA
Autofee process for IM runs according to scripted rule set marked by FVA
eg pay Xbp for rec USD delta cleared at CME
future : bilateral IM 8

9. Conclusions
Inventory trading desks well equipped to understand costs per inventory unit
Portfolio costs discretise well by counterparty but not by asset class
Resource management desks “translate” actual funding costs to incentive models
Portfolio funding costs not practical to decompose into inventory in many cases
Substitute incentive models : eg liquidity charge for trading beyond risk tolerance
Resource management desks can also aggregate fungible inventory costs and execute portfolio hedges
Collateral switch risk
Unsecured exposure risk
Frees trader resource and maximises efficiency
Risk stripping and incentive models can be built into pricing systems
Other models could be explored
Sales driven resource management
etc 9