MarketFactory’s James Sinclair on pre-trade risk management
Has risk management kept pace with execution in terms of speed?
It’s catching up and will be there. Limit-monitoring mishaps, including those that brought down trading firms and caused prime brokers (PBs) to exit the market, show the market has not always kept pace. The manner of sending credentials to traders and allowing them to trade in the name of a major bank, without a central risk monitor, has not kept up with the times. Limit monitoring can be very decentralised, relying on the executing brokers and ECNs to keep track of their piece of the puzzle.
However, the market is aware of the issue. We started providing pre-trade risk controls to our customers two years ago. We were already investing in the fastest code base, and that gave us the latency budget to calculate pre-trade limits and still be just as competitive in the market. Everyone sleeps better at night because of this.
Is post-trade risk management now inadequate on its own?
It’s belts and braces. Pre-trade is becoming essential for most applications, but post-trade will always be important as a component of trading infrastructure best practice. I don’t subscribe to the notion that you can or should do every aspect of risk monitoring pre-trade.
What’s the biggest challenge from a risk management perspective considering the current market structure?
Can I choose three – two technology challenges and one market challenge?
First, massive market fragmentation means checking up to 50+ venues. We therefore control risk at the point of entry into the market. We never let an order pass into the market that would break a limit.
Second, solutions have to be scalable, and that means being non-invasive. Many customers have existing feed handlers and their own custom software that works for them. They don’t want changes. They don’t want any translation of their messages – what they send to an execution venue should be exactly what the execution venue receives. Our risk checks have to work with everyone without exception, and without latency or changes to their software.
Third, PB limits are tight, as we know. Clients have been off-boarded and rates raised. The criteria to become a PB customer are much stricter. Risk managers are being more cautious – and no wonder. Recent events have shown that history is an even less reliable indicator of the future than we all assumed.
We are in uncharted macroeconomic territory. FX Week ran a recent story with a great little summary outlining many of the new risks (Flash Crash moves loom in FX Market, May 6, 2015).
Hervé Hannoun of BIS said in a speech in May that the unprecedented number of countries with negative interest rates is “taking Europe to the boundaries of the unthinkable”. And he hadn’t yet mentioned Greece.
The tight PB limit situation may yet be temporary, and prime-of-prime providers have stepped up solidly to fill the gap.
The credit provision space changed dramatically post January 15. Would wider use of pre-trade risk management tools have lessened the impact of the event on the industry?
The issues of January 15 were less about pre-trade risk technology and more about the market’s assessment of risk. In hindsight, the FX market greatly underestimated market risk – the potential loss that may be incurred by holding a position. Leverage was therefore too high and collateral held too low. The Swiss franc’s move was almost double the size of any major currency move since Bretton Woods. So, given those leverage ratios, people got hurt.
That said, January 15 drew attention to the broader subject of risk management, including pre-trade controls. With the spotlight on risk, we have the opportunity to show pre-trade controls’ worth.
Realistically, we can’t reduce market risk. We can help assure risk managers that operational risks are well managed and positively affect the overall risk equation. If we think of a ‘risk budget’, we can make room for expanded market risk by reducing operational risk.
Where do you see increased adoption of such tools?
Almost every role in the market. Prime brokers are using pre-trade risk to monitor customers, ensuring they stay within the terms of their designation notices. Bank e-commerce teams take comfort in a completely independent third-party risk check further policing limits. Pre-trade risk checks will become a staple of every fund and bank, both for prudent safety checks and formal credit. And the FX market will be safer for it.