BEST EXECUTION talks to MIRKO MARCADELLA, chief product officer for LIST, an ION Company, about how the onset of algo trading and the increase in automation across derivatives has impacted the evolution of risk management – especially under the current turbulent market conditions.
What has been the evolution of holistic risk management and surveillance for the derivatives markets?
In recent years, risk management has evolved from an ‘end-of-day’ or even ‘next day’ process to an intraday, real-time function that combines multiple angles: surveillance, market and credit.
With the onset of algorithmic trading, the introduction of sponsored access and increasing volumes of trades—all combined with the shift to intraday processing, largely due to the turbulent market conditions—has driven regulators, markets and trading firms to increase supervision and surveillance of trading activity.
The overall infrastructure has evolved in several ways. Regulations like MIFID II and other processes have been introduced to protect markets and investors from disruptions caused by mis-programmed algos or against market-manipulation attempts. Exchanges have also started introducing circuit-breakers and pre-trade risk checks, and more importantly, brokers themselves are adopting more sophisticated intraday risk control frameworks. Today, firms approach monitoring and reporting of derivatives risks either through a narrow compliance-focused lens or a wider lens that allows them to see the complete picture of its risks in a timely manner.
What are the traditional barriers to effective risk management?
One of the major barriers to effective risk management is the complexity of the modern trading environment. Firms are commonly managing multiple trading platforms as a result of a range of client requests: for instance, on equities, financial institutions typically use one trading platform while when trading derivatives, brokers commonly use multiple trading platforms driven by client requests.
However, one of the biggest hurdles when using multiple trading platforms is the consolidation of all trading information. This typically includes integrating and managing pre-trade limits as well as monitoring the consumption of limits across multiple systems, evaluating risks as close to real-time as possible while taking open orders into account.
These conditions are particularly challenging for businesses that strive to monitor risk at a speed that is as close to real-time as possible. Managing such complexity requires an exception management approach, which generates alerts when limits are breached and defines escalation procedures. It also suggests the various actions that need to be performed depending on the different levels of risk. All of which helps risk managers to handle increased trading volumes and navigate volatile markets efficiently.
Why have traditional risk departments become less of a middle-office function and more of a business-critical area?
Risk departments have no doubt evolved into a critical priority for businesses of all sizes, mainly owning to events such as 2008-09 financial crisis, and more recently, the pandemic and the war in Ukraine among other recent black swan events. Businesses are now viewing proactive risk management as an important tool to build resilience and in turn, grow profits in difficult market conditions.
By having a robust risk management function, firms can better manage client expectations as they’re now able to identify, evaluate and mitigate risks in a timely manner. This has resulted in building stronger, more transparent relationships between brokers and their clients.
What’s more, a good risk management framework allows businesses to focus on the bigger picture i.e., building a good reputation and expanding the business. Clients like to work with brokers who have the evidence to prove that they can protect their business should something unexpected hit. For brokers, on the other hand, if they have faith in their risk management framework, they can then focus resources on more business-critical functions, allowing firms to provide a more seamless service to existing clients and attract new ones.
How can businesses increase the efficiency of their compliance teams and the resilience of their systems?
What sets a good compliance team apart is their data management skills and whether processes are automated or not. Risk management systems need to be fed high quality data if businesses want to reduce false positives as well as automate so we’re not relying on manual processes anymore—which bring with it a whole new set of risks. Like anything we do, when it comes to risk management systems, we sure reap what we sow.
In addition to ensuring high quality of data, the best risk frameworks should also be designed to integrate and centralise data—in near real-time—across back office, middle office and trading systems. This not only improves the time taken to make decisions but also the quality. These frameworks also improve performance by giving businesses an integrated view of how well their organisation can manage a unique set of risks and minimises the chances of encountering risks that are yet to be identified.
What are the advantages of risk platforms that support intraday and end-of-day risk management?
Brokers deal with different types of clients: from those that are developing their trading and investment strategies over a medium-long period of time, and need to be monitored intraday and end-of-day; to those, like liquidity providers, who don’t carry positions overnight but are generating massive intraday exposures.
To monitor risk today, an end-of-day view is not sufficient. If brokers want the best results, intraday and end-of-day risk platforms should be integrated with pre-trade, at-trade and post-trade risk management — to constitute a single risk management framework. This is important because it increases the ability of the risk platforms to protect financial institutions from different types of risk.
A system that can integrate intraday and overnight positions and evaluate the different types of risks at the same time is a much more effective and beneficial strategy, especially in the more extreme conditions we are seeing today.
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