O R O™ (Operational Risk Offset) enables financial firms to efficiently hedge their exposures to operational risks from securities and cash transactions performed in the normal course of business.

A specialist fund functions as a hedge pool to match asset and liability streams utilizing the predictive analytics in ContextMetrics™. The hedge pool is capitalized by qualified (institutional) investors who are offered a rate of return benchmarked to established market indices.

O R O™ participants (eg, custodian banks) hedge their exposures (eg, failure to process a corporate action) by securing "Participation Options" (PO) sold over-the-counter. The value of the PO's for potential purchase will be based on the risk forecast provided by ContextMetrics™ at a specific point in time (eg, a 98 percent probability of fails for a tender offer where remediation is valued at USD 0.7 million as-of two days prior to settlement). Draw-downs from the hedge pool will be made only if the O R O™ participant explicitly exercises the option to do so.

The advantages to using PO's are :

• relevance based on current risks (rather than generic a priori estimates from historical fails)
• capital-efficient since PO's are acquired only when absolutely needed
• cheaper than traditional insurance
• based on transparent and readily understood factors articulated by ContextMetrics™; and
• simplifies attribution and expense allocation to specific perils and the originating counterparty.

To minimize moral hazard, the cost of acquiring a hedge is conditioned by a 'reputation' ranking derived from :

• the frequency and severity of historical risk alerts generated by ContextMetrics™; and
• the number and magnitude of actual PO draw-downs exercised.

Note that O R O™ participants are clearly incented to improve their 'reputation' rankings and minimize their exposures to operational risk. This generates a significant emergent benefit across the ecosystem of securities counterparties that, over time, will result in more efficient operations and potentially reduced capital set-asides (especially for larger firms who utilize the Advanced Management Approach (AMA) per Basel II).

The ability to hedge or insure operational risk at peril-specific levels may now be economically feasible. Traditional insurance has largely been costly and inconvenient for its users because of the lack of innovative policies that address specific features of the operational risk landscape.

forward look, inc's research into capital-market based alternatives for peril-specific offsets has resulted in a practical and readily usable approach enabled via O R O™. In brief, contingent capital provides securities trading firms the option to raise capital when they expect to need it most (eg, after the occurence of an operational error coupled with the unavailability or depletion of budget reserves).These capital markets based products (eg, "Participation Options" (PO) described previously) function like barrier options where the so-called barrier is not an index (as with typical derivative products), but is rather a defined risk or loss specific to a particular workflow (eg, the amounts due from a custodian who fails to process a rights offer correctly).

There have been other capital-based risk management products developed in the past such as an "op risk loss equity put" that allows buyers to fund operational losses by issuing new securities at a pre-loss price (For more details, see Webb, A. 1999. 'Controlling Operational Risk'. Derivatives Strategy, January 1999). However, the advantage that our O R O™ Framework brings is the specificity of funding calls relative to the causal agents (based on the analytics provided by ContextMetrics™, the source of the operational risk is identifiable).

Unlike traditional financial derivatives which involve optionable interest (eg, the fixed-rate payer does not have to have a natural exposure to rising LIBOR as a requirement for doing a LIBOR interest rate swap), the PO's are in fact linked to risks which the participant is naturally exposed to. We mitigate the traditional insurer's concern with moral hazard by

• ascertaining that the participant has an insurable interest
• using the unbiased outcomes from ContextMetrics™ to drive the cost of the PO; and
• using a 'reputation' ranking derived from the frequency and severity of putative risk alerts generated by the participant, and the number and magnitude of actual PO draw-downs exercised.