The need for speed is arguably pushing the boundaries of front-office risk management far more than potential regulation
Financial markets have always been adaptable and as they have also shown since the start of the subprime crisis, they are surprisingly resilient. But as a recent panel discussion on front-office risk management at the SunGard City Day in London showed, this is not down to pure chance. Sometimes a huge amount of thinking is required behind the scenes to ensure that they do keep functioning as most participants and also regulators require.
The panel, which was moderated by Bob McDowall, research director at TowerGroup, was always likely to draw a large audience given its topicality. And this was boosted by the fact that it followed straight on from Europe’s first ever public discussion on the difference between sponsored and direct market access (DMA). This had highlighted many of the issues which are really pushing the boundaries of front-office risk management*.
As Leslie Sutphen, global head of eSolutions at Newedge, pointed out, global regulators may well be trying to instigate and implement more pre-trade risk management, but most firms are able to cope with this relatively well. “Our general position as a broker is that we’re already concerned about our credit and our balance sheet…I don’t feel strongly that regulators and exchanges should be telling us how to protect our own balance sheet,” she said, adding: “That said, I’ve been working with my colleagues from firms such as JP Morgan, under the auspices of industry associations, to encourage exchanges to give us the tools to protect our balance sheets.”
Advances in trading technology and the push to reduce latency appear bigger issues. “We at Newedge do require pre-trade risk management for clients trading DMA with us and we also require it for our sponsored direct access clients: we use mechanisms to ensure that they have it (pre-trade risk management) in place,” Sutphen pointed out.
“That said, pre-trade risk management can be quite crude at the trading platform level. It’s generally things like fat finger and order size limits, or crude position limits which don’t aggregate across asset classes and platforms. But we still believe there should be some kind of break in place….we do a lot of work and invest a lot of money in this and we would very much like our partners in the business, including the exchanges and vendors, to work with us to make this more efficient and standardized,” she added.
Beware the technology gap
According to Stephane Leroy, global head of sales and marketing at QuantHouse, a provider of end-to-end systematic trading solutions, there is potentially a technology gap between banks and brokers and what he termed ‘silicon traders’. “I’m not sure the technology is there yet to cope with the silicon traders. It will certainly need some extensive discussion between brokers, exchanges and the clients,” he said, before supporting Sutphen’s claim that some front-office risk management is basic. “A lot of the existing (risk management) tools are considered as ‘old age’ by silicon traders,” he claimed.
Antonio Reyes, managing director of electronic client solutions at JP Morgan, believes that the supposed risks around high frequency trading may have been a little overstated. “High frequency is one of the latest packaged products we’ve launched….from a risk management point of view, I think our pre-trade process starts in the KYC (know your client) process. You really have to know your customer, irrespective of whether they are using black boxes or putting trades through a screen and doing a couple of trades a day, you need to understand what they are up to and what your real credit exposure is,” he claimed.
Reyes questioned how much a pre-trade filter could protect any broker, but added that, especially with regard to sponsored access, the exchanges were perhaps not delivering the tools brokers need to comply with their regulations.
Give us the tools
“If they (the exchanges) want us to comply with rules, they need to make it possible for us to see their (the clients’) working orders, see their trades and to intervene electronically if something is going wrong. It is not adequate in this high-frequency world to have to call the exchange and ask them to cut of a client…we’re not asking for more regulation, but more tools so we can protect ourselves,” he argued.
“You cannot be in a situation where you have a specific liquidity venue telling members ‘you must pre-trade risk manage’ which is in parallel selling collocation data centre space to non-members to access the venue directly,” he continued.
Reyes takes the view that the quest to reduce latency has been pushed too far, which has compromised risk management. “If it takes two minutes to manage risk pre-trade, then that has to be built into models. If you take the extreme example – cash equity markets – some of our clients could send 1,000 orders a second. If you don’t manage risk pre-trade, the first time you find out about a defective order, it’s too late. By the time you react – it could take you at the very least two minutes to dig out the phone number, call the exchange and tell them to pull the plug – 1,000 orders times two minutes times thousand shares per order is a lot of exposure in two minutes. Some people may be comfortable with that, but JP Morgan isn’t.”
If we could get rid of it….we would
Sutphen agreed with the view that firms, such as Newedge and JP Morgan, were almost being pushed into providing a service, sponsored access, that they did not want to offer. “Exchanges and liquidity providers have marketed that type of access directly to our clients, and some of our clients feel that they need it in order to be competitive. It used to be that the type of client who wanted that type of access was a small market-making operation, and we would generally say no or make sure they were housed within our premises. But now it’s not just small market-making firms; it’s large hedge funds, large pension funds, it’s generally almost everyone out there who feels they need to have low-latency access to the markets. If we could get rid of it, I think we would,” she contended.
Not surprisingly, Reyes agreed. “The challenge we have is that we’re not on a level playing field. It depends on your appetite for risk how far you will go. In the US cash equity market, we feel cornered. It’s becoming a client retention issue,” he said, before asking the audience if it knew which firm was responsible for one of the greatest number of trades on the New York Stock Exchange and NASDAQ in 2008. It was a regional broker specialized in correspondent clearing services for the hedge fund/broker dealer community. That’s not what you’d expect. I would guess that up to 80% of their flow is sponsored access. You find out what’s been done from the exchanges’ drop copies. I’m sorry, but that’s a level of risk that firms like JP Morgan and Newedge can’t take.”
It is clear that there are some very real fears around sponsored access and it may be that the regulators do not fully understand what is going on. “The regulators could do with going out and hiring as consultants the most profitable high-frequency traders on the street…they need to understand them to regulate them. How are you going to limit high-frequency traders: by limiting CPUs on machines?” asked Reyes.
Sutphen again agreed: “What is required is meaningful dialogue. I think the regulators are behind where they need to be in understanding what’s going on,” she concluded.
*Since the SunGard City Day in London on September 24th, SEC, the US regulator has published several bans or proposals regarding flash trading, the regulation of dark pools as well as sponsored access and co-location, confirming the high profile this issue currently has.
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