IIROC, Aviva Investors, Credit Suisse and NASDAQ OMX contribute their insights to our latest discussions on the techniques and technologies of risk management.
Controlling Risk in Today’s Market The Canadian Safety Nets
By Deanna Dobrowsky, Vice President, Market Regulation Policy, IIROC
Canadian regulators, like their counterparts around the globe, have worked to establish a framework to mitigate risk in electronic markets.
We have designed various rules to work as a series of safety nets to protect against events that can lead to unintended outcomes in a high-speed market.
The safety nets are tiered and provide protections, offered by different industry stakeholders, at multiple levels. This layered approach to risk management mitigates risk at different stages in the life cycle of an order, and places the responsibility of protecting the system on various parties.
The four safety nets include:
At the dealer level, automated controls to prevent the entry of orders that can disrupt a fair and orderly market;
At the marketplace level, thresholds that prevent orders from executing at unreasonable prices
Single-stock circuit breakers administered by the Investment Industry Regulatory Organization of Canada that address rapid, significant and unexplained price movement in a particular security; and
Market-wide circuit breakers which halt trading on all equities marketplaces when there are declines in prices that affect the market generally.
Dealers and Automated Pre-Trade Controls The first safety net is maintained by participants – dealers that trade directly on marketplaces and may act on behalf of clients. New requirements (the “Electronic Trading Rules” or “ETR”) have expanded on existing rules to specifically require risk management and supervisory controls related to marketplace access and the use of automated order systems. The ETR require participants to use automated controls to prevent the entry of an order that:
• Exceeds pre-determined credit or capital thresholds, • Exceeds pre-determined value or volume limits, or • Violates market integrity rules or securities regulation.
In particular, a participant that uses an automated order system must have appropriate procedures to detect, prior to entry, an order that is clearly erroneous or unreasonable and which would interfere with fair and orderly markets. The ETR came into force on March 1, 2013.
Marketplace Thresholds The next tier of safety net is at the marketplace level. To date, exchanges and alternative trading systems have not been required to employ volatility controls or trading thresholds. This has resulted in inconsistent, and in some cases non-existent, safeguards on the marketplaces. IIROC has been given the mandate to set marketplace price and volume thresholds, but specific limits have not yet been determined. IIROC has issued a concept paper on this topic and further proposals on marketplace thresholds will be published for comment.
Single-Stock Circuit Breakers Single-stock circuit breakers, which apply to securities included in the S&P/TSX Composite Index as well as to exchange-traded funds, were put in place in February 2012 to address rapid, significant and unexplained price movements in a particular security. A five-minute halt is triggered across all equities marketplaces if the price of the security swings 10% or more within a five-minute period between 9:50am and 3:30pm. Applying a single-stock circuit breaker to securities in a broad-based index reduces extreme volatility in those securities and, by extension, dampens the volatility of the index.
Market-Wide Circuit Breaker The fourth and final safety net is the market-wide circuit breaker which halts trading on all equities marketplaces when there are declines in prices that affect the market generally. Market-wide halts of this nature have historically been, and continue to be, tied to the market-wide circuit breaker in the US. Thus trading halts on all Canadian equities marketplaces generally are triggered based on the decline in the S&P 500 Index from its closing value on the previous day.
Underpinning the Safety Nets As described above, the Canadian safety nets function as part of a multi-tiered system to control short-term, unexplained volatility. Where these measures do not apply or in exceptional circumstances, IIROC will vary or cancel trades that have a negative impact on fair and orderly markets. IIROC’s ability to intervene when required is the final measure strengthening this framework of risk mitigation and management.
Managing Risk in Fixed Income
With Trevor Leydon, Head of Investment Risk for Fixed Income at Aviva Investors.
Like a lot of larger firms, we operate a matrix-style control system for risk management. For things that are electronically-traded, obviously, you can have a little bit more rule-based systematic control, and for OTC and phone-based markets, it’s a little bit more challenging. We try and adopt our controls to reflect a variety of factors, from client appetite to our own risk appetite to market depth. We try and use as many tools as we can to effectively control risk.
We make it as systematic and with as much pre-trade compliance and pre-trade checks as we can, within reason. From specific things like; can the client mandate handle this type of instrument, this particular stock or bond, or the size of the order, there are a variety of control mechanisms in place and those have to be factored into the broader decision-making process that we as a house will go through. There are human controls via the PM and the individuals concerned, and our investment managers proactively engage with the risk team and compliance to think about size, and to talk through any particular points that are of concern while they are going through the idea generation phase, and then onwards from that we try to implement the controls so they are inherent going forwards but minimise disruption.
“Does your firm use TCA to measure execution performance and if yes, how effective a tool do you find it?”
Ian Firth, Aviva Investors, responds
Aviva Investors both subscribes to and supports the use of Transaction Cost Analysis (TCA). We acknowledge there are limitations, both with available systems and market data. We aim to identify trends and ways to improve our trading strategies, and we have spent a great deal of time and resources to continually improve the process we operate. The key to efficient TCA is accurate data and efficient time stamping. This will demonstrate where within the cycle of the order there are inefficiencies. All of our equity trades are subject to review, although a small number may fall out due to the fact specific markets and benchmarks in those markets are not provided/supported.
Trades are loaded on a daily basis and there is commitment from dealers and our in-house execution analyst to ensure that as much information as possible is attached to clearly identify specific trades. Regular reports with details and exceptions are sent to portfolio teams and management to monitor the ongoing performance of dealers, brokers and execution venues. We compare against various benchmarks, with Implementation Shortfall (IS) being our primary benchmark. There is greater discipline in recording all attributes, whether price limits, volume restrictions or direction from the fund manager, in order to identify exceptions and where appropriate identify these trades.
We have seen, and continue to see, an improving trend to our execution capability. We are able to easily identify outliers and explain the reasons for these. Improving results have helped with our profile and we have been able to distribute the results of our trading capability to end clients. We have received positive feedback from our clients, both direct and end, due to the results and the knowledge applied to explain said processes and results.
Brian Mitchell, Gartmore, responds
Yes; Gartmore’s monitoring and analysis of dealing efficiency is aimed at helping to reduce trading costs, identifying potential deficiencies and helping to ensure that our investment processes are in line with the highest market standards for buy-side best execution.
As part of our effort to ensure cost effective execution, we perform detailed TCA and within that we focus, amongst other things, on both the explicit and implicit costs of trading. Explicit costs include equity commission rates, ticket charges and local taxes. Implicit costs, which can account for more than 85% of overall implementation costs, include: (i) market impact (the cost of the bid/offer spread plus the price movement in excess of the bid/offer spread needed to trade the required volume immediately); and (ii) opportunity cost (the performance impact of not instantaneously completing the execution of an order).
While we use broker-led TCA offerings, (across our cash equities, PT and Algo business flows), we do not solely rely on them, given the potential lack of impartiality. It is also difficult to compare trades transacted by competing brokers, as most will inevitably use differing methodologies. We currently use an independent TCA service to help analyse in detail the true impact of equity trade implementation on client accounts and to analyse Broker / Dealer performance, sending them all trade data from our OMS on a weekly basis.
We participate in an anonymous peer group TCA database, to review our rankings on a wide variety of metrics and, as such, this is an effective tool for comparative work. We can compare our trading costs at the aggregate and/or regional level with others on a more realistic, difficulty adjusted basis.