© Z/Yen Group

2015

Long Finance – What Are The Frontiers For The Risk Management Profession?

Professor Michael Mainelli FCCA FCSI FBCS

Executive Chairman, Z/Yen Group

© Z/Yen Group

2015

Z/Yen Group Limited

Risk Reward Managers

90 Basinghall Street

London EC2V 5AY

United Kingdom

tel: +44 (20) 7562-9562 www.zyen.com

“Zest for Enlightenment”

PRMIA Webinar

Long Finance What Are The Frontiers For The Risk Management

Profession?

Professor Michael Mainelli

Executive Chairman, Z/Yen Group Limited michael_mainelli@zyen.com

4 February 2015

@mrmainelli

© Z/Yen Group

2015

♦ Special – City of London’s leading commercial think-tank

♦ Services – projects, strategy, expertise on demand,

coaching, research, analytics, modern systems

♦ Sectors – technology, finance, voluntary, professional

services, outsourcing

Independent Publisher Book Awards Finance, Investment &

Economics Gold Prize 2012 for The Price of Fish

British Computer Society IT Director of the Year 2004 for

PropheZy and VizZy

DTI Smart Award 2003 for PropheZy

Sunday Times Book of the Week, Clean Business Cuisine

£1.9M Foresight Challenge Award for Financial £aboratory

visualising financial risk 1997

Z/Yen

© Z/Yen Group

2015

1. Do you recognise four or more of the

following terms: 1. Predictive Analytics or Big Data 2. Dynamic Anomaly & Pattern Response 3. Activity-based Cost Variance 4. Environmental Consistency Confidence 5. Confidence Accounting 6. Prediction Markets 7. Enterprise Risk/Reward Management

Quick Poll Question

© Z/Yen Group

2015

Agenda

♦ Research agenda

♦ Experiments

1. DAPR

2. Activity-based cost variance

3. Environmental Consistency Confidence

4. Confidence Accounting

5. Prediction markets

6. Enterprise risk/reward management

♦ Long Finance & Money

“Get a detailed grip on the big picture.”

Chao Kli Ning

© Z/Yen Group

2015

♦ Blockchains (current)

♦ Long Finance predicting bubbles (current)

♦ LIBOR and FX litigation (current)

♦ Prediction markets (1998-present) –

www.extzy.com

♦ Market Intelligence – Ministry of Defence,

e.g. Vision 2020 (1994-present)

♦ Avatars for Big Data (2010-2012)

♦ PropheZy and VizZy – Automation of

Compliance monitoring (2003-2008)

♦ Financial £aboratory Club visualising risk

(1997-1998)

Z/Yen in Finance Research

© Z/Yen Group

2015

Finance - Pricing Risk is All

Risk Selection

Value Pricing

Customers

Capital

“If a man will begin with certainties, he will end in doubts;

but if he will be content to begin with doubts, he will end in certainties.”

Francis Bacon

© Z/Yen Group

2015

Financial £aboratory 1996-1998

Display

Usa

ge

Realistic

Analagous

Abstract

Zone 1 Zone 2

Zone 3 Zone 4

Symbolic

Spreadsheets

Road Signs

VCR Controls

Flight Simulators

© Z/Yen Group

2015

Best Execution Research 2004-2005

The trades in the centre are

those that fell within the

bid/offer spread

The trades on either side

were executed outside the

bid/offer spread

© Z/Yen Group

2015

Predicting Price Movement 2005

Broker B: Differences between Actual and Predicted Price Movement Bands (by day)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 98 99 100

Trade date code

Num

ber

of o

bser

vatio

ns (a

s a

perc

enta

ge o

f the

dai

ly to

tal)

Difference within 4 bands Difference within 5-9 bands Difference within 10-14 bands Outliers (Difference of 15 bands or more)

© Z/Yen Group

2015

Compliance Workbench 2005

These four trades are the most anomalous

(the difference between actual and

predicted is 18)

This set of trades are the least anomalous

(the difference between actual and

predicted is 1)

© Z/Yen Group

2015

Incidents & Losses 2005

0

2

4

6

8

10

12

Ja

n-0

3

Ma

r-03

Ma

y-0

3

Ju

l-03

Sep-0

3

No

v-0

3

Ja

n-0

4

Ma

r-04

Ma

y-0

4

Ju

l-0

4

Sep

-04

No

v-0

4

Ja

n-0

5

Ma

r-05

Ma

y-0

5

Ju

l-0

5

model actual

© Z/Yen Group

2015

LIBOR 2007-2008

© Z/Yen Group

2015

LIBOR 2006-2008 (2012)

© Z/Yen Group

2015

Existing Approaches

Standards -

fiduciary ratings

ISO9000, SAS70

Manual Necessity 6Ʃ

6.0 3.4 99.9997%

5.0 320 99.98%

4.0 6,210 99.4%

3.0 66,800 93.3%

2.0 308,000 69.2%

1.0 690,000 30.9%

Sigma DPMO Yield

Process Modelling

© Z/Yen Group

2015

2. Which is the most important thing to control

risk?

a. Measure

b. Motivate

c. Manage

Quick Poll Question

© Z/Yen Group

2015

Philosophical Splits

Six Sigma ISO9000

Total Quality

Checklists

Procedures

Inspection

Numerical targets

Engineering

Automation

Contribution

Commitment

Culture

Measure Manage

Motivate

© Z/Yen Group

2015

The Year(s) of OpRisk in Finance?

♦ 199X to 200X – market and credit

analogies

♦ 2007 – present, crises and reputation

♦ Technology

♦ Knowledge - what price risk?

♦ Willpower - why do anything? no capital

allocation?

♦ Discipline - imposed? Basel?

“Perfect numbers like perfect men are very rare.”

René Descartes

© Z/Yen Group

2015

Nupe Sand Divining

[Source: http://www.necep.net/scripts/detail.php?id=89]

© Z/Yen Group

2015

Activity-Based Cost

Variance

Kierkegaardian Doubt = Faith

Annual Volume and the r2 of the Relationship Between Cost per Trade and Trade Volume

1

10

100

1,000

10,000

100,000

1,000,000

10,000,000

100,000,000

1,000,000,000

US S

tock

Len

ding

Europ

ean

Cas

h Equ

ities

Europ

ean

Sto

ck L

ending

Europ

ean

Exc

hang

e Tra

ded

Der

ivat

ives

Europ

ean

Bon

ds

US E

quities

Globa

l Cur

renc

y Opt

ions

US B

onds

Europ

ean

Rep

o

Globa

l FX

Globa

l Mon

ey M

arke

t

Globa

l Van

illa E

quity

Opt

ions

US R

epo

Globa

l Cre

dit D

erivat

ives

Globa

l IR D

erivat

ives

An

nu

al

Vo

lum

e T

rad

ed

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

r2

Total Volume r2

Dynamic Anomaly &

Pattern Response

Systems

Environmental

Consistency

Confidence

KRI Losses

Enterprise Risk/Reward

Management Systems

TIS_deals_done

600 1200 100 180 0 5 15

2000

3500

600

1200

TIS_deals_amended

TIS_deals_entered_late

60

140

100

180

Contracts_sent_after_delivery

X30_day_stdev_brent_price

0.5

2.0

3.5

05

15

BITS_incidents_occurred

2000 3500 60 140 0.5 2.0 3.5 0 5 15

05

15

BITS_incidents_discovered

Prediction Markets

Scenario Planning

Portfolio Analysis

Confidence Accounting &

Real Options

© Z/Yen Group

2015

1. Dynamic Anomaly & Pattern Response

♦ Dynamic Initiates an action

Real-time

♦ Anomaly & Pattern Identifies unusual behaviour

Reinforces successful patterns

♦ Response Adaptive, moves with the data

Integrative, can work without rebuilding the entire IT architecture

© Z/Yen Group

2015

Anomalies

Y Axis: Share Identification Code

X Axis: Actual & Predicted Price Movement Bands – the length of the yellow link indicates the difference between the prediction and the actual value - the longest links represent the anomalous trades

Z Axis: The Difference between Actual

& Predicted Price Movement Bands

© Z/Yen Group

2015

♦ Best execution compliance automation

♦ Operational risks and losses

♦ LIBOR surveillance

…

♦ FX surveillance

♦ Liquidity prediction

♦ Non-STP correction

♦ Customer targeting

♦ Trade performance benchmarking

♦ Opening prices

♦ Automated “tipster” and “avatars”

♦ Anti-money laundering…

Dynamic Anomaly & Pattern Response

In Finance

© Z/Yen Group

2015

2. Activity-Based Cost Variance

Operations

simulation

model

PURCHASE

REQUISITIONS

DATA

VALIDATION

(x3)

CAPITAL APPROVAL PROCESS

PURCHASING OFFICERS

(x5)

TYPISTS

PURCHASE

ORDERS

(x3)

PURCHASING

MANAGER

APPROVAL

(x2)

CLERICAL

SUPPORT

(x3)

COMPLETED

PURCHASE

ORDERS

SERVICES

CONSUMABLES

STOCKS

CAPITAL

WO

RK

BU

FFER

WO

RK

BU

FFER

WO

RK

BU

FFER

WO

RK

BU

FFER

WO

RK

BU

FFER

Purchasing function process flow

rp3 rp1 rp6 rp5 rp4 rp2 Prod

Resource assignment table

Sta

ff C

lass II

a

b

c

d

rp3 rp1 rp6 rp5 rp4 rp2 Prod

Resource assignment table

Sta

ff C

lass I

a

b

c

d

rp3 rp1 rp6 rp5 rp4 rp2 Prod

Resource assignment table

Sta

ff C

lass II

a

b

c

d

Prod rp1 rp2 rp3 rp4 rp5 rp6

Resource assignment table

Sta

ff C

lass I

a

b

c

d

Cost assignment to products Product Cost Pools

A B C D E F

Total

Costs Resource

Pools

RP1

RP2

RP3

RP4

RP5

RP6

Cost assignment to products Product Cost Pools

A B C D E F

Total

Costs

Resource

Pools

RP1

RP2

RP3

RP4

RP5

RP6

Cost assignment to products Product Cost Pools

A B C D E F

Total

Costs Resource

Pools

RP1

RP2

RP3

RP4

RP5

RP6

Cost assignment to products Product Cost Pools

A B C D E F

Total

Costs Resource

Pools

RP1

RP2

RP3

RP4

RP5

RP6

UNIT

PRODUCT

COSTS

Products Unit cost

Class I

A

B

C

D

E

F

Class II

A

B

C

D

E

F

Class III

A

B

C

D

E

F

Class IV

A

B

C

D

E

F

MANAGEMENT

ACCOUNTS

COST

ASSIGNMENT

RULES

TRANSACTION VOLUMES

OPERATIONAL MODEL FINANCIAL MODEL

© Z/Yen Group

2015

3. Have you used statistical process control in

your organisation?

a. Yes

b. No

Quick Poll Question

© Z/Yen Group

2015

Annual Volume and the r2 of the Relationship Between Cost per Trade and Trade Volume

1

10

100

1,000

10,000

100,000

1,000,000

10,000,000

100,000,000

1,000,000,000

US S

tock

Len

ding

Eur

opea

n Cas

h Equ

ities

Eur

opea

n S

tock

Len

ding

Eur

opea

n Exc

hang

e Tr

aded

Der

ivat

ives

Eur

opea

n Bon

ds

US E

quities

Globa

l Cur

renc

y Opt

ions

US B

onds

Eur

opea

n Rep

o

Globa

l FX

Globa

l Mon

ey M

arke

t

Globa

l Van

illa

Equ

ity O

ptions

US R

epo

Globa

l Cre

dit D

erivat

ives

Globa

l IR D

erivat

ives

An

nu

al

Vo

lum

e T

rad

ed

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

r2

Total Volume r2

OpRisk Activity-Based Cost Variance

© Z/Yen Group

2015

4. Can you predict the incidents and losses

attributable to today

a. Yes

b. No

Quick Poll Question

© Z/Yen Group

2015

3. Environmental Consistency Confidence

KRI Losses

♦ Key Risk Indicators and

Basel

♦ DAPR and KRI loss

prediction

♦ Loss KRI prediction

♦ Why tick-bash and model-

build until you have KRI’s?

TIS_deals_done

600 1200 100 180 0 5 15

2000

3500

600

1200

TIS_deals_amended

TIS_deals_entered_late

60

140

100

180

Contracts_sent_after_delivery

X30_day_stdev_brent_price

0.5

2.0

3.5

05

15

BITS_incidents_occurred

2000 3500 60 140 0.5 2.0 3.5 0 5 15

05

15

BITS_incidents_discovered

© Z/Yen Group

2015

It’s Only A K-RI If It Predicts!

location

ID

HR-

Headcoun

t #

HR-

Joiners in

month

HR-

Leavers in

month

IT-System

Disruption

Incidents

#

IT-System

Downtime

hr:mm

FO-Trade

Volume #

FO-Trade

Amendme

nts #

OPS-

Nostro

Breaks #

OPS-

Stock

Breaks #

OPS-

Intersyste

m Breaks

#

OPS-

Failed

Trades #

OPS-

Unmatche

d Trades

#

RIS-

Market

Risk Limit

Breaches

#

AU-High

Risk O/S

Overdue

Audit

Issues #

AU-High

Risk O/S

Audit

Issues #

1 136 6 11 2 0.350694 19218 317.1111 3 9 6 463 52.77778 0 0 4.5

2 121 6 11 2 0.03125 8999 0 17 4 2 26 0 3 0 4.5

3 23 6 11 0 0 661 8.777778 3 0 0 0 7.444444 0 0 4.5

4 30 6 11 0 0 4307 80.55556 7 1 1 17 0 1 0 4.5

© Z/Yen Group

2015

Challenging OpRisk Through Prediction

Challenge

indicators

Health indicators

(errors found, delays,

backlogs)

OpRisk incident/cost

measures

Action indicators

(remedial, projects,

controls)

y = 0.2943x + 93.86

R2 = 0.4144

y = 340.45e0.0004x

R2 = 0.4783

0

200

400

600

800

1000

1200

1400

1600

0 1000 2000 3000 4000

Deals done (monthly)

Deals

am

en

ded

(m

on

thly

)

y = 0.0121x - 6.3194

R 2 = 0.3186

y = 8E-06x 2 - 0.0021x

R 2 = 0.34

0

2

4

6

8

10

12

14

16

0 200 400 600 800 1000 1200 1400 1600

Deals amended

BIT

S in

cid

en

ts o

cc

urr

ed

© Z/Yen Group

2015

Why Did We Need This?

♦ You manage what you measure

♦ Distinguish “expected” loss from

“unexpected” loss, in order to

reduce the former through better

decisions

♦ Financial risk dashboard

♦ Contribution to the Economic

Capital view

♦ Preparation for increasing regulation

© Z/Yen Group

2015

5. Do you present ranges and confidence

intervals about assets to your external

auditors?

a. Yes

b. No

Quick Poll Question

© Z/Yen Group

2015

4. Confidence Accounting

© Z/Yen Group

2015

5. Prediction Markets

© Z/Yen Group

2015

6. Enterprise Risk/Reward Management

comparator

sharing best practice

claims

strategic risk valuation

premia

notifications

and investigations

External Markets Internal "Pool"

Risk/Reward Unit

Unit A Unit B

Operations

Organisation

© Z/Yen Group

2015

Ris

k

Likelihood

sh

are

ho

lde

r

vie

w

de

bto

r

vie

w

reg

ula

tor

vie

w

activity-based cost analysis*

& operational reliability

event-loss databases &

benchmarking*

enterprise risk/reward

management systems*

mutual risk management* &

external/re-insurance

extreme value theory &

last resort

debt/equity requirements &

subordinated debt issues

Rew

ard

event frequency

Dealing with Uncertainty

© Z/Yen Group

2015

Risk/Reward Civilisation

Value

Complexity

enterprise risk/reward management systems

detailed calculations

risk reporting simulation

transaction maps

regulatory

compliance

external risk markets

dynamic anomaly

& pattern response

transfer pricing

capital allocation/internal markets

activity-based cost variance

tick-bashing

environmental consistency

confidence

KRI Loss prediction

standards - fiduciary ratings,

ISO 9000, SAS 70

stochastic accounting

prediction markets

© Z/Yen Group

2015

Impertinent Questions

© Z/Yen Group

2015

London

Accord

Financial

Centre

Futures

Meta-

Commerce

Eternal

Coin

About

‘When would we know our

financial system is

working?’

Objectives:

Expand Frontiers

Change Systems

Deliver Services

Build Communities

© Z/Yen Group

2015

6. Can your senior management answer the

question, “What is money?” to a child?

a. Yes

b. No

Quick Poll Question

© Z/Yen Group

2015

Single Prices?

P

Q

Supply Demand

P1

P2

Liquidity Black Hole ‘Event Horizon’

© Z/Yen Group

2015

Lunacy, Heresy, Or Orthodoxy?

“Get a detailed grip on the big picture.”

Chao Kli Ning

© Z/Yen Group

2015

Money As Technology

Money

Fiat currency

Common tender

Backed

Unbacked

Commodity money

Composite

Baskets

- currencies

- commodities

Representative money

“Money is a technology

communities use to

trade debts across

space and time.”

“Tokens of

indebtedness are social

desires frozen at a

point in time – tokens

depend on the future

persistence of the

community and its

values.”

© Z/Yen Group

2015

♦ What is the value of money if one person holds all the cash?

♦ What happens if you call your tax authority and tell them you

just don’t feel part of the community but will call when you’re

back in the mood?

♦ What is the value of £1 in France versus a pound in the

Shetlands?

♦ Why can’t you go to your central bank and ask for a ‘bucket’

of GDP?

♦ What happens to the value of a government’s money during

a civil war?

♦ If your nation won the ‘put your feet up for a century’ lottery

– in what currency would you take your winnings?

♦ Is the Euro a tax scrip?

Ignorance About Money

© Z/Yen Group

2015

Evolution In Time & Space

♦ Money 0.0 – communal village

♦ Money 1.0 – social tokens

♦ Money 2.0 – traded value, Mesopotamia

♦ Money 3.0 – gold & silver 1.0, Lydia

♦ Money 4.0 – bills of exchange, Northern Italy

♦ Money 5.0 – fractional reserve goldsmiths

♦ Money 6.0 – central banking 1.0 – cheques, 17th century

♦ Money 6.5 – gold & silver 2.0, 19th & early 20th century

♦ Money 6.0 – Richard Nixon & ultra-leverage

♦ Money 7.0 – ?

© Z/Yen Group

2015

The Long-Term?

Theme Service Question Trust Identities communities Space Transactions services Time Debts value-added

© Z/Yen Group

2015

Money is the self-

referential system upon

which all our financial

analysis is based:

♦ community values

♦ economic activity over

space

♦ debts over time

Trust-Time-Space

[Source: http://illusionsetc.blogspot.com/2005/08/moving-mobius-strip.html]

© Z/Yen Group

2015

Welcome to Knightian

Ignorance

“Are You Not Thinking

What I’m Not Thinking?”

When Would We Know Our Commerce Is Working?

“Get a big picture grip on the details.”

Chao Kli Ning

© Z/Yen Group

2015

© Z/Yen Group

2015