This blog post also appears on ATMonitor.
The regulatory push towards real-time trading risk management was addressed in a panel session at the 2012 SunGard Industry Seminar in London. The discussion pulled together of a lot of useful information for participants, but ultimately didn’t generate too much controversy. It seems that the regulators are for the most part pushing at an open door with their demands for tighter pre-trade risk controls. Stories abound, we’re told, of risk management teams now able to pursue projects they had long thought important or even necessary, but had historically lost out to other competing priorities.
During the panel discussion, Simmy Grewal of Aite Group presented a round-up of the major regulatory initiatives that touch on this area. It’s a considerable list.
- The U.S. SEC Market Access Rule (15c3-5) is designed to eliminate “naked access” to equity execution venues and requires brokers to establish pre-trade risk controls in all cases.
- The U.S. CFTC’s proposal for position limits on commodity derivatives (part of the Dodd-Frank legislation) still faces legal challenges, and requires more work on establishment of futures/swaps equivalents, but if enforced later this year, will effectively require global controls of pre-trade risk.
- In the EU, the MiFID II proposals include text that implies ESMA will develop commodity derivative position limit standards similar to those of the CFTC.
- Also in the EU, ESMA’s Guidelines on pre-trade risk management for automated trading engines are currently being incorporated into national regulations.
- The real-time application of credit valuation adjustment (CVA) techniques to provide accurate measures of counterparty and liquidity risk exposures in OTC markets is required under the Basel III rules.
Stuart Adams of FIX Protocol Limited brought an interesting perspective to the discussion: FPL has been very active in the pre-trade risk field, and is due shortly to publish an update to its 2011 Risk Controls guidelines, extending their scope to cover listed derivatives as well as equities.
Throughout the discussion, the panel addressed questions around three different areas.
How real-time can risk management be?
You don’t get more real-time than pre-trade – which is now being required in a range of cases. The major difficulty with being fully real-time is that in most trading firms of any size there will be multiple trading architectures in use, and also there will be trading on multiple exchanges. Limits and margin then have to be allocated and shared across them, and it’s hard to do this optimally. This is a particular challenge in derivatives trading, given the complexities of managing margin. Risk also has to be managed across related asset classes – typically futures, options and swaps.
The push for better risk management comes at the same time as an urgent priority on lower latency. This places tight limits on how much checking you can do pre-trade and creates a challenge for software builders – how fast can they make the checks run? As a result, we see firms making necessary practical compromises: for example, pattern risk controls (recommended in the FPL Guidelines) are generally placed post-trade.
Where do buy- and sell-side firms need to place emphasis in their compliance efforts?
There are difficult decisions here, given that many other issues are live at the same time, particularly in Europe, with the rest of MiFID and the MAD review. But getting pre-trade risk management right, across the industry, has to be a major priority. There will be no excuses for anyone breaking a limit.
Firms need to ensure that comprehensive software controls are in place for all electronic trading, whether from screens or automated trading engines. Where these already exist, the systems in place and how they are configured need to be reviewed. Not all systems will be capable of handling all checks in 15c3-5 or the ESMA Guidelines. Firms also need to ensure that the controls are well documented.
The challenges multiply where different markets and diverse trading architectures are involved, but technology solutions exist that can help optimize the management of such environments.
Can some real business benefits be gained at the same time?
Arguably, given the scale of what can happen in an electronic trading environment, every trading firm should be on the same side as the regulators. We’ve certainly seen examples of both brokers and buy-side firms using the regulations as a lever to make risk management or technology improvements that did not previously get budget or resource focus. This shouldn’t come as a surprise. We are, after all, talking about the avoidance of what could in the worst case be catastrophic risks.
This panel session amounted to a general agreement that there is little point in fighting the regulatory direction on pre-trade risk management and that in many ways it will benefit business. The big issues include assuring the quality of systems for each trading architecture and asset class, and deciding how far to go with the more complex controls in order to optimize the use of available capital and margin.
While you’re here…