An earlier VaR blog, Value at Risk (VaR): Overview and Benefit Case, provided an introduction to Value at Risk (VaR). We critiqued “industry standard” VaR definitions, reviewed the history of VaR analysis, and summarized its benefits. In this blog, we will consider the unique challenges of VaR system implementations. VaR projects have similarities and differences compared to other system implementations. Understanding these will position your team for success.
Emphasize Proper Project Management
Commodity trading and risk management (CTRM) system implementations are notoriously difficult. According to Patrick Reames at Commodity Technology Advisory, over 50% of implementation projects fail to some degree – they either do not meet all important requirements stated at the beginning of the project, materially miss timelines and/or budgets, or are complete failures and never put into production. See our separate CTRM Project Management Done Right series to improve your odds.
While CTRM system implementations are challenging enough, VaR system projects are more specialized and even more challenging for several reasons:
- VaR systems are relatively complex in terms of mathematical techniques, computational demands, and associated technical configuration;
- The variety of VaR project stakeholders, the scope of their responsibilities, and their mathematical and business acumen vary more significantly than for most projects. For example, the goals and emphases of the global SVP of trading, who is subject to VaR limits, are quite different from those of the PhD quant who is responsible for maintenance of the VaR models;
- Greenfield VaR projects have difficult change management requirements, particularly related to training. The math behind VaR can be daunting to some stakeholders, and intuition can be difficult to develop;
- The quantity and quality of historical price data required to support VaR analysis is often the most difficult and tedious part of VaR projects; and
- Calculated results are difficult to validate during user acceptance and parallel testing. Often comparable legacy models are not available, requiring custom testing tools that involve complex mathematics.
These challenges are commonly underestimated, and they conspire to put great demands on a project manager. Project risks can be mitigated by utilizing a project manager who understands the special needs of VaR projects, and who employs rigorous methodology and effective governance (e.g. weekly status reviews with senior stakeholders).
For the balance of this blog, we’ll refer to the first two very important phases of a VaR project as Planning and Design & Execute. Terminology may vary, but the approach described below can be incorporated into any project management methodology.
Planning – The Most Important Project Phase
It is difficult to overstate the importance of the Planning phase of any implementation, and this is particularly true for VaR projects. Planning takes little time or cost relative to the balance of the system implementation, and it significantly de-risks your project.
The Planning phase of a VaR implementation should establish:
- Governance – composition of the steering committee, meeting cadence, etc.
- Stakeholder analysis and required project resources – as mentioned above, VaR projects place demands on a wide variety of skills including commercial, quantitative, and technical.
- Relation to risk policy – what risks will the project measure, and should other future ambitions be considered? For example, VaR projects can provide a framework for advanced counterparty credit risk analytics.
- Scope and objectives – what are the project’s objectives and what is in/out of scope (or not yet determined)?
- Phasing – how will scope or project complexity be stepped into? Phasing de-risks most projects. Progressive VaR training is an important element of a phasing plan.
Design & Execute
Next, we’ll address what is unique about the Design & Execute phase of a VaR project. Attention to the following topics will improve VaR implementations.
- Market risk hierarchy – ensure that key stakeholders agree on the nature and relationships between market risks. Industry standards exist for modeling many market risks (e.g. most natural gas basis relationships and a dozen crude and product “flat price” benchmarks), but many others require policy decisions (e.g. whether a specific physical crude market is best modeled as a basis to Brent or Dubai).
- Trade types and market risk factors – develop inventories of all transaction types, important events in their life cycles, and their associated risk factors. Foreign currencies may need to be considered, as well as interest rates for long-dated positions.
- Risk granularity – will VaR be measured in standard monthly “buckets,” or in more detail? Will that vary between markets (e.g. weekly Brent CFD’s or hourly/daily power prices)?
- Risk analysis goals – are VaR calculations the basis of limits, capital adequacy or other regulatory requirements, investor reporting, or performance measurement?
- VaR methodology(ies) – what VaR model or models are most appropriate for your business model and risk management needs?
- Historical data requirements and sourcing – based on the above, what historical data is required, what already exists, and how clean is it?
- Business scenarios and process definition – how will VaR analysis and reporting be integrated into daily and monthly processes?
- Alternatives analysis – evaluation of alternatives which were determined to be in scope (e.g. model choice, phasing, commercial system selection, etc.)
- Reporting requirements – specification of reports for data validation, limits, other management reporting, performance, etc.
- Test planning – what are acceptance criteria for completing the project, and what methods will be used to validate project results?
Several of these analyses are interesting (and/or difficult) enough that they will be the topics of future blogs.
What if VaR is Embedded in My CTRM System?
You may wonder, “Is implementation really this difficult if VaR is included in my commercial CTRM system?” It depends; there are trade-offs, and most of the challenges described above still apply.
There are two types of VaR systems: integrated and independent. Independent risk analysis tools such as systems licensed by SAS and Lacima must be integrated with upstream deal capture tools and price feeds, as well as downstream reporting solutions. In general, independent VaR systems are more specialized and consequently can provide broader features, deeper capabilities, and more extendibility. Their challenge is the cost of developing and maintaining the interfaces mentioned above.
VaR comes integrated with some commercial CTRM systems, such as Allegro and Endur (both licensed by ION Group). These systems solve the integration problems described above, since deal capture, price feeds, and reporting are already incorporated in the broader CTRM solution. However, implementation of the VaR module within the CTRM solution requires the same attention to stakeholders, mathematical complexity, training, and testing mentioned in the previous section.
If you have not yet built or licensed a VaR system, the best way to determine which approach (or commercial product) is best for your firm is to analyze your requirements and perform a gap analysis, comparing your needs to each alternative’s features. Many project difficulties arise from premature decisions to build a custom solution or license a particular commercial solution before this fit is evaluated. Time and again, we see teams commit to creating a custom product or helping a small vendor develop new capabilities as a “beta customer.” While there is a time and a place for both, custom and beta development projects have different risk profiles, which should not be taken lightly.
For most firms, the challenges associated with VaR projects are more than rewarded by improved understanding and management of risks in their business. As suggested by Phillipe Jorion, who literally wrote the book on VaR, Value at Risk, the process of implementing these projects may be even more beneficial than the final VaR estimate.
At Veritas Total Solutions, our team of experts is versed in VaR and other trading & risk advisory capabilities. We offer advisory services in commercial strategy, organizational structure and capabilities, and technology solutions. If you are interested in learning more about our capabilities, contact us to learn more or subscribe to our blog to stay connected!