A Web of Interdependencies
The banking system can be viewed as an interlocking web of contracts, such as loans, swaps, repos, etc., which impose obligations and risks on counterparties, and therefore interdependencies. As the financial crisis revealed, these interdependencies can cause the entire system to collapse when exposed to some unforeseen event.
The root of the problem is that a single bank has a hard time figuring out their obligations with their own counterparties, and the problem is several orders of magnitude higher when trying to calculate the risks involving multiple banks.
“When we want to aggregate what the liability of a bank against any counterparties, it’s not an easy task to do,” Khaldoun Khashanah, a professor at Stevens Institute of Technology in N.J., told Markets Media. “Then across enterprises, it’s even more difficult because they are not speaking the same language in the sense of having a reference database for the contracts.”
Khashanah, who hold a Ph.D. in applied mathematics and mathematical physics and modeling, and his colleagues have created a financial and instrument reference database called ACTUS. “It aims to build an open source that generates contingent cash flows analysis based on contractual obligations,” he said.
The objective of the project is to develop a set of about 30 unique contract types (CTs) that represent virtually all existing financial contracts and which generate contingent cash flows at a high level of precision. The term of art that describes the impact of changes in the risk factors on the cash flow obligations of a financial contract is called “state contingent cash flows,” which are the key input to virtually all financial analysis including models that assess financial risk.
“In the course of our research we determined that the total number of cash flow patterns that you have in the world are approximately 30,” Khashanah said. “If you can algorithmically encode the cash flow patterns of contractual obligations, then you are able to aggregate the risk and say that under these circumstances and events, the system on the aggregate could collapse. That’s the type of analysis that we would like to see at the systemic level.”
Had ACTUS existed in 2008, there could have been a means to evaluate the assets held on certain investment firms’ books – which might have helped maintain market confidence and set the U.S. Economy on a more stable trajectory.
“We believe that this project, combined with the successful completion of the FSB LEI effort, will impact every activity related to financial risk assessment,” Khashanah said. “It will significantly improve regulation of individual institutions, monitoring of systemic risk, and enterprise risk management. It will also make possible new avenues of research into systemic risk that will make financial markets safer and more efficient.”
A standardized data set has been developed for the six most heavily used contract types (the algorithms are available via open source at www.projectactus.org), which cover about 50 to 55% of entire transactions in the world, according to Khashanah. The next six contract types are scheduled to be complete by March 2015.
The work on ACTUS complements that of other organizations, such as the Enterprise Data Management Council’s FIBO (Financial Instrument Business Ontology) and the Global LEI (Legal Entity Identifier).
The European Central Bank asked Khashanah’s group to map its bond portfolio to ACTUS,and a large U.S. financial institution is interested in applying ACTUS to its swap portfolio. “What we would like is to map their swap portfolio to see how it performs under ACTUS and then subject that scenario to a risk and stress test,” said Khashanah. “The thing that also makes this interesting is that it goes to the side of transparency that is mandated by Dodd-Frank. It’s not only mandated by Dodd-Frank. Actually, the industry itself wants to be more transparent at this point.”
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