Risk management was revolutionized in 1988 by SPAN, the first system to calculate futures performance bond requirements exclusively on the basis of overall portfolio risk at both the clearing and customer level.
Innovation in new products and front-end access to markets has been the key to CME Group leadership in the futures industry for many years. Its many firsts - such as financial futures and cash-settled contracts - and its role in pioneering electronic trading are widely recognized among fi nancial markets participants and observers. However, one behind-the-scenes, back-office concept has not received as much visibility, but may have been just as important to the growth and development of today's fi nancial marketplace. Marking its 20th anniversary this year, the Standard Portfolio Analysis (SPAN) system has revolutionized risk management since the exchange introduced it in 1988.
SPANNING THE GLOBE
Essentially, SPAN calculates performance bond requirements to ensure that the funds available are suffi cient to meet most market events - but not so excessive that customers and clearing fi rms have more money tied up than necessary. During its evolution over the last 20 years, SPAN has become the industry standard for portfolio risk assessment and is now used by more than 50 registered exchanges, clearing organizations, service bureaus and regulatory agencies around the world.
"When we were trading just futures, calculating margins was relatively simple and straightforward," says Ed Gogol, managing director, clearing solutions at CME Group. "But when options on stocks were introduced in the mid-1970s and on futures in the early 1980s, and options trading took off, determining margins was not such a simple matter."
Depending how positions and strategies in a portfolio were decomposed, calculated margins could be quite different. If they were too low, a clearing house might be put at risk; if margins were set too high, it could be an impediment to trading, Gogol explains.
MEETING A NEED
So the exchange undertook a high-priority project to bring margining into the modern world by simulating the effect of various conditions on a portfolio as a whole.
An early attempt was too complicated for customers to understand, but then-CME Group economist Jerry Roberts developed the core concept of what became SPAN. It was rolled out initially in December 1988, a little over a year after the October 1987 stock market gyrations provided a further illustration of why such a risk assessment system would be a valuable tool for exchanges and clearing organizations.
SPAN separates the margining analysis process into two components. The first involves the value of the options or other instruments based on price changes during trading. The second involves a risk array, a set of numeric values that indicate how a particular contract will gain or lose value under various risk scenarios.
Each exchange or clearing organization has its own contracts, prices, etc. as input for the first function, while SPAN packages the risk array fi les that make calculating margins a simpler arithmetic calculation that is easy to explain and practical to implement. Based on the degree of confi dence they want to establish and the number of days that the risk exists, exchanges can fine-tune the system by setting parameters such as price scan ranges, volatility scan ranges, intra- and inter-commodity spreading rates, and rules and short option minimum parameters.
"SPAN basically adds simulations to price inputs," Gogol explains. "It is a specific methodology in a family of value-at-risk methodologies. Instead of looking back at what has happened, it evaluates what I call 'looking forward risk.' How much more might you lose if a portfolio declines in value?"
INNOVATIVE SUCCESS
What started as a risk assessment solution for futures and options became the foundation for risk evaluation in many different markets.
"SPAN is an algorithm that worked - an example of the innovation of standardization," says Dale Michaels, managing director, credit and market risk management at CME Group.
"This standardized engine for all risk management tools saved the industry money, and most new exchanges want it to make their products more accessible."
SPAN is now being applied to a broad range of fi nancial instruments and markets and is constantly expanding its reach into a wide variety of new products, including FXMarketSpace, bonds, interest rate swaps, over-the-counter derivatives and other instruments that can be specifically tailored for an exchange.
Aside from its range of applications and flexibility, one of the reasons for SPAN's wide acceptance is that CME Group realized all exchanges had the same problem in evaluating risk and decided to offer the trademarked methodology to other exchanges and clearing organizations at a nominal rate. Today, all U.S. futures exchanges and many international entities, including LCH. Clearnet SA, Japan Securities Clearing Organization (which clears the Tokyo Stock Exchange), exchanges in Sydney, Singapore, Hong Kong, and nearly 50 others around the world, have adopted SPAN to assess risk and establish minimum margin requirements.
LCH.Clearnet has been using SPAN for almost 15 years, according to Christine Huant, LCH.Clearnet risk management project deputy manager. The firm implemented SPAN in 1994 for MATIF, the Paris exchange for futures and options contracts on interest rates and futures on index and commodities products, then extended the use of SPAN into Euronext and a number of other European exchanges. LCH.Clearnet uses the algorithm designed by CME for futures contracts but implemented its own pricing models in SPAN for equity, index and currency options because options cleared by LCH.Clearnet are not futures-style options. CME specialists and LCH.Clearnet's risk team collaborated closely on a cash securities algorithm based on SPAN logic.
"The last improvement, thanks to SPAN RMC software, was the implementation of realtime intraday margin calculations," Huant says.
"It was a success following a two-year project and since the end of March 2007, has allowed LCH.Clearnet to improve its real-time risk monitoring on derivatives markets. Every hour during the day, LCH.Clearnet is able to monitor the full real-time valuation of each member's portfolios, initial margin and variation margin by taking real-time trades and prices into account."
THE SPAN FAMILY
Now in its fourth generation of functionality, SPAN has evolved into a family of three software products:
PC-SPAN is a basic single-user desktop version that provides a quick, inexpensive and simple way to calculate SPAN margin requirements across multiple exchanges. It was originally used primarily as a tool for auditors.
SPAN Risk Manager is also a single-user desktop program, but adds risk analytics to the margin calculation. Customers can use various options models and what-if analyses to see the impact of changes in price. Futures commission merchants can incorporate this second level into their bookkeeping function in their clearing fund calculations.
SPAN Risk Manager Clearing is an institutional- level program used by exchanges, clearing organizations, service bureaus and regulatory agencies. It brings SPAN's capabilities into real-time margining and risk array calculations and produces SPAN risk parameter files and reports. As market prices move continuously, SPAN Risk Manager Clearing uses current prices as inputs and determines, if a trade is executed at that price, what is the portfolio's overall position and what is the risk? Software accomplishes this analysis in milliseconds for real-time risk management.
"One of the single biggest ways the basic version of SPAN is used is to verify margins - whether they are correct or not," Gogol comments. "SPAN improves transparency and makes the margining process better for customers, who now can verify margin requirements themselves."
Comparing today's SPAN to the fi rst efforts in 1988 is like "comparing today's Porsche to a Model T," Gogol says.
"Without SPAN, you wouldn't have had the ability for clearing firms to easily process trades from the explosive growth in futures and options volume that we have seen in the last 20 years, which could have impacted future growth," Michaels contends. "If CME Group hadn't developed SPAN, someone would have had to invent it."
" SPAN is now being applied to a broad range of financial instruments and markets and is constantly expanding its reach into a wide variety of new products, including -the-counter derivatives and other instruments that can be specifi cally tailored for an exchange." "Margin" and "performance bonds" are often used interchangeably in traders' conversations, but there is a difference between the concept of "margin" in stocks and the traditional term "margin" in futures, options and other derivatives. In stocks, a buyer may pay as little as 50 percent of the share price, which acts as a down payment for stocks that are owned, and the balance is paid with "margin" money provided by the brokerage firm. In futures, "margin" really means only a performance bond or good-faith deposit, which both buyers and sellers must provide to assure that both parties to the trade will fulfill the responsibilities of the transaction. Futures do not involve ownership but only temporary control of a contract at an established price.
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