By: Steve Woodyatt, Chief Executive Officer, Object Trading Also published by Futures & Options World October 23, 2013 Regulations driven by the G20, both finalised and yet-to-be, are putting pressure on all market participants in the trading lifecycle to improve their approaches to real-time risk management and pre-trade risk controls. But really, firms should not wait for regulations to force their hands, because actively managing their approach to pre-trade risk can improve overall operational efficiency and is ultimately good for business. Sang Lee from Aite Group summarised the problem, “You would think that things should be more intuitive, streamlined and integrated; but that’s not the reality we live in. Buy side clients are using multiple trading platforms, execution management systems, vendor gateways, and execution broker pipes. The brokers are dealing with fragmented markets, fragmented and siloed internal trading infrastructure, and fragmented trading relationships. The client’s total exposure may be fragmented across multiple execution brokers and more than one clearing member. In addition, the brokers’ own infrastructure may be extremely complex due in part to both organic growth and acquisitions”. To find out more about the various issues brokers are facing surrounding risk management today, Object Trading interviewed several managing directors of trading and prime brokerage for listed derivatives at some of the largest global financial institutions. Not surprisingly, all of our interviewees preferred to remain anonymous, but permitted us to share some of their insights on many of the latest emerging themes in risk. Below are a few of their insights and my suggestions for how the industry can benefit from new approaches. For more depth and other insights, check out our research report: Removing the Limitations – Shedding the Complexity of Exchange Connectivity.
Need for Uniformity in Market Access
Every person we interviewed is dealing with a complex web of legacy technologies and little uniformity. No single front-office trading system provides all the needed functionality or market access, so firms have to support multiple trading front ends and execution management systems (either vendor supplied, and/or home grown). Each order generation source has its own tightly coupled market access infrastructure, so firms end up maintaining a cobbled patchwork of redundant market connectivity, gateways, and infrastructure. A head of listed derivatives clearing and market access explained, “I was using multiple gateways in Europe because none of them connected to all the exchanges. So a European futures client wants to trade in Asia, I’m going to have to connect them to a different gateway. Oh, you also want to trade options in Europe? I’m going to connect you to another system. So they have to go through different gateways, different FIX specs, different risk limits…it’s a mess. Then we upgrade one system and the client wants to know why they can’t get the upgrade on the other system”. He continued, “Clients want one API across all exchanges. They want you to make everything else look seamless. Upgrade one API, that’s it. We needed a reliable system that offers global coverage and competitive latency”. To achieve this, firms must redefine direct market access by decoupling order generation from market access and execution infrastructure. This enables sell-sides to give clients and their own trading desks access to their preferred trading tools while employing a single interface by which they access the markets. Normalised market data, order execution and risk controls simplify the client’s ability to connect – allowing them to focus on their trading strategy development instead of dealing with exchange interfaces. Streamlining gateways reduces costs by eliminating duplicate connectivity. Streamlining and simplifying also reduces trading outages introduced by operational complexity. Eliminating the complexity can go a long way to improving customer experience.
Need for Normalisation in Pre-Trade Risk Controls
All of our interviewees agreed about the need for standardisation of risk functionality across all of a firm’s various trading systems. At present, there is no standardised approach to pre-trade risk controls. Some risk constraints are provided by the screen vendor products, some are embedded into legacy gateways, some are provided by the exchanges. As Paul Rowady, Senior Analyst from Tabb Group explains, “Each of these platforms has its own risk controls, and they are generally not interlinked. So, executing and clearing brokers use various pre-trade and post-trade controls that may be inconsistent across the various platforms. This makes aggregating and managing risk pre-, at-, or near-trade difficult and expensive. There is a lack of uniformity in risk settings. The non-uniform application of risk controls limits firms’ ability to effectively understand and manage their overall risk”. Risk checks like fat finger tests are common to most systems providing market access. However, the way they go about implementing specific constraints varies. A global head of market access and electronic trading stated, “What we were finding [was] that vendors [and exchanges] all determine the way a check would work in their own way. So we ended up with hundreds of different methodologies for performing the same class of risk check”. A head of electronic brokerage and market access explained, “We run fifty systems. We have fifty sets of risk checks if we run fifty systems. We have fifty different methods of input in those risk checks. Administration across fifty systems is a complicated world. I think standardisation and simplification is probably the methodology that most banks are leaning towards, particularly because everyone’s trying to cut costs”. This issue was echoed by several of the brokers we interviewed. Sang Lee pointed out, “Ironically, some of the complexity introduced in the trading process is due to the client’s own risk management strategy. This is especially true for the give up relationships with multiple clearing members, which are done to reduce counterparty risk. There are valid business reasons for the web of relationships in the industry. But because of the complexity, finding transparency and uniformity in risk management approaches is not as straightforward as the regulators might think”. Decoupling order generation from market access and execution infrastructure can give institutions a way forward. By decoupling, banks and brokers can still support the front ends demanded by clients while leveraging a normalised gateway with standardised risk checks on the back end.
Need for Uniform Pre-Trade Risk Data
Most views of risk are at the exchange level and don’t aggregate across markets. As the head of listed derivatives clearing and market access explained “We’re setting risk thresholds for each market. But markets are getting more efficient and correlated. We need to see aggregated risk. Inflexible risk parameters can cause you to shoot yourself in the foot”. Inflexible parameters also waste opportunities for efficient allocation of risk capital. The problem is that each market gateway has its own data model, so the pricing, order book and risk information coming out of these systems is inconsistent. Many of these systems are closed, making the risk information accessible only through the trading screens or proprietary APIs. Others are more open, but the systems don’t talk to each other. This makes it virtually impossible to aggregate risk data across exchanges. Risk officers need access to uniform risk data across exchanges. Feeding this uniform data into their risk systems allows them to get a comprehensive view of a client’s exposure. The same head of listed derivatives clearing told us about a recent meeting with his risk team, “I was in a meeting the other day with another vendor. They spent a lot of time building risk tools, and they came up with this module for OTC trading and clearing. Most likely the way they look at it is accurate. But the guys in risk hated it. They said ‘You’re not going to tell me how to run my business. I’m not going to buy a pre-made, ‘ready to throw in the microwave type of solution’.” Every broker approaches risk differently, based on their franchise, the market segment they serve, their technology and their clients. Different buy side clients represent different types of risk. Risk officers need access to uniform data “ingredients” to perform their jobs, but they also need the flexibility to create different risk “recipes” depending on the situation. But many of the systems available on the market are too rigid, offering canned, out-of-the-box functionality for risk enforcement and/or management. When it comes to emerging regulations, all brokers will need to solve the same compliance dilemmas. But each firm will go about attaining the end result differently, since their businesses are not identical. And all banks need access to the same type of normalised data elements. They just also need the ability to aggregate this information as they see fit to get a complete view of their clients’ exposure.
Responding to Change
In our interviews, several brokers also expressed dissatisfaction with their ability to be proactive in updating risk technology to reflect new regulations. Some of the interviewees felt that some vendors lack awareness and a sense of urgency when it comes to identifying the specific updates needed and getting these changes finished prior to regulators’ deadlines. This can be particularly challenging for brokers that work with numerous vendor gateways and need to implement the same changes across all their various systems. Let alone the wide geographical diversity of regulation, all with different interpretations and compliance requirements. The truth is that regulations can be very broad and ambiguous, making them difficult to implement. No one can predict exactly how regulators will finalise upcoming rules, and this creates a great deal of uncertainty. The best thing financial institutions can do is to ensure they have the infrastructure to simplify the process of making needed updates. Decoupling the order generation infrastructure from the market access infrastructure can simplify the process. It allows the risk constraints to be standardised across all markets. When mandates shift, a single change to enforcement renders all dependent systems compliant. Some firms have elected to standardise on new platforms built in house. But building and maintaining these tools internally can quickly become an overwhelming task. The constant updates issued by exchanges and the continual barrage of new regulations means firms will have to focus extensive resources on something that does not provide much competitive advantage. That is only going to distract the firm’s technology team from innovating to improve their core business. Conversely, normalising the enforcement of risk checks underlying regulated processes simplifies compliance for dependent systems. As a result, leveraging a vendor that offers a single API to all the markets means teams can shift focus to innovation and pleasing customers.
Taking on Today’s Demands
Most market participants are preoccupied with tactical approaches to complying with the many regulations being introduced around the globe. But a narrow focus prevents firms from leveraging new capabilities for strategic benefit. The over-arching theme in emerging regulations is that institutions should be able to see and manage their overall exposure cross-asset and cross-market in real time. Today, most firms can’t even do this in one asset class, let alone across the firm. Managing risk pre-trade across the enterprise based on overall exposure is not only possible; it’s good for business. Today, forward-thinking financial institutions are beginning to realise that the steps they have to take to adapt to these emerging regulations may ultimately have a positive impact on their business. Measures like consolidating and normalising exchange access and risk controls can remove a great deal of complexity. Simplification can lower costs, and the right platform can both improve risk management and give technology teams the foundation upon which to innovate. To read more about the results from Object Trading’s research, visit our blog.