Neal Goldstein, J.P. Morgan, Timothy Furey, Goldman Sachs and Greg Wood elaborate on the forthcoming FPL Risk Subcommittee’s Risk Management Guidelines including their extension to cover DMA, symbology and futures.
While margin checks do not fit into the typical pre-trade risk check, how can traders assimilate the risk limit functionality of FIX with their margin-level risk monitoring?
Neal Goldstein, J.P. Morgan:
Pre-trade risk checks are a key element of the comprehensive risk management strategy applied for business lines like prime brokerage. For electronic trading relationships where a client is offered leverage based on some level of collateral, real time positions for each client are usually calculated based on start of day, and intra-day drop copies of execution reports. A typical risk control is to link the post-trade position checks with the pre-trade checks applied at the gateway. If a client’s intra-day position approaches a level that exceeds the pre-arranged leverage or margin agreements, the post-trade system can send a cut off signal to the pre-trade gateway. The client would then be allowed to liquidate the position to reduce the long/short positions, but not go any further long or short.
The basic definition of DMA trading is that brokers provide access to a venue in the most efficient and effective way possible. What can brokers do to ensure they do not miss client risk limits, internal counterparty checks, rule 15c3-5 requirements, etc while maintaining speed of access?
Timothy Furey, Goldman Sachs:
Whether using algorithms, smart order routing and/or DMA to access the market, it is important to make sure that the rules are optimized and that automated testing and checkout processes are in place to verify that they are working. Appropriate risk controls are a key part of execution and are baked into the process. With all the advances in technology, development teams have the ability not only to better optimize the execution path for speed and efficiency, but also to provide benefits like automated testing to check that controls are functioning properly.
How important is symbology validation to equity risk controls? Can better technology remove fat finger errors from trading?
Greg Wood:
Symbology validation is very important to any type of electronic order flow since the broker must clearly identify the instrument being traded by the client. An erroneous validation of a symbol could have serious repercussions in how the order is executed in the market, including inadvertent disruption to the market. One of the key rules of engagement when a broker certifies a FIX connection with a client or vendor is for both parties to agree what symbology is being used on the session and then not to deviate from that without a subsequent recertification.
Risk management technology is definitely evolving alongside trading technology to provide better controls for the way people are trading now. A simple fat finger check can prevent an inadvertently large order being sent direct to the market. However clients are increasingly using algos to trade large orders over a longer duration or using different types of interaction with the market. In this situation the fat finger check is deliberately large to allow the order to be submitted to the algo. The algo then needs to assess whether the parameters of the order – instrument, aggression, duration, time of day, etc – are suitable for the size of the order. If a large order has parameters that are too aggressive in comparison to the average daily volume of the instrument and the desired timeframe for execution then the algo should either reject or pause the order to avoid impact to the market. If this happens then the broker and client should discuss how to adjust the parameters of the order to avoid impact.
How applicable are these recommendations to futures as well as equities?
Greg Wood:
We approached this document knowing that we would include a set of risk management checks for futures and options. During writing it became clear that the majority of checks were common across all exchange listed instruments, and the only real differences were around how you approach credit checks. Since futures and options are inherently leveraged, the concept of a notional check typically is not applicable because settlement is based on the margin requirement for the instrument. As this may vary daily – especially for options – actual credit checks are commonly performed post-trade for listed derivatives, and position checks are typically used on a pre-trade basis as a proxy for credit.
These guidelines demonstrate that regardless of actual market structure, the same good practices always exist regardless of asset class. For example, it is important to run checks at the pre-trade level to avoid fat finger mistakes as well as reducing the possibility of taking out too large a position, and it is important to check for duplicate, stale or runaway orders from a client’s system. With the growing adoption of execution algorithms for futures and options, the concept of managing risk within the algo also applies. It is imperative to avoid adverse market impact by comparing the order against the calculated average traded volume of the instrument. This is especially true for less liquid long dated maturities or strikes in the same way that it is true for a less liquid stock. If this results in an algo order being paused while the broker and client discuss how to proceed, then this can help avoid inadvertent impact to the marketplace and provide a consistent user experience regardless of whether a stock, future or option is being traded.
How is the FIX tag approach (103=21) an improvement of the prior pause mechanisms? How will the Tag 58 text be standardized?
Neal Goldstein, J.P. Morgan:
The intent of the new FIX convention is to provide a message construct to reduce the ambiguity when an order is in an intermediate state between new and acknowledged, after a given risk threshold has been breached and the order has been paused. The FPL Risk Management working group engaged many of the industry leaders in the 3rd party vendor OMS/EMS product space, who indicated that they can leverage this message to provide buy-side clients with added clarity on the state of a paused order. The information incorporated in FIX Tag 58 is going to be used to populate the text field in the OMS/EMS popup window to indicate that the order exceeded a given risk threshold. For the initial implementation, we expect that the information in Tag 58 will vary across sell-side broker’s products. I believe that over time, we will apply further standardization.
