Fabricio Oliveira, Head of Risk Management at Mirae Asset Global Investments Brazil, discusses his approach to pre-trade risk controls and how local market structure influences the occurrence of risk.
Market Open At Mirae we do much of our trading with offshore entities. For example, we have funds that are administered in Hong Kong, Luxembourg, Brazil, US and Korea and this geographical disparity creates operational risk. Differences in settlement price, currency and the timing of financial transfers are all aspects that must be considered when using offshore funds. The ability to settle a US trade in the US and not in another time zone is also important. This is particularly true of Hong Kong as our time difference is a huge barrier to trades in Asia. It is almost impossible to book these trades in Hong Kong even though our traders here see the opportunity to do so.
When I focus on the risks for open trading, the settlement movement is an important concern. Whether you are focused on market risk or liquidity risk, all risks need to be monitored, so you can have a clear view of what potential risks lie ahead.
High Frequency Trading There is much discussion in the industry and at conferences about high frequency trading (HFT) in Brazil, but we are not yet ready for high frequency strategies. The industry is starting to see how HFT works, but liquidity in Brazil across asset classes is insufficient to support these strategies. There are approximately 300 listed companies in equities and about half that number in derivatives, whether in bonds or yield curves or currency. The local players who run HFT strategies focus on the few stocks and derivatives with liquidity, which does not give them many options to find alpha over short periods. It will be interesting to see how it works in North America and Europe and for us to consider what might be possible in Brazil. For now, I do not see many players in HFT and I can count on one hand the number of funds using HFT.
Our pre-trade risk controls have not had to account for HFT volumes and speeds yet, so we have focused more on core control mechanisms. We have some vendors who can produce risk controls for the current liquidity. If we have liquid stocks, derivatives or OTC products, then we can define our own risk controls. Fund houses with hundreds of funds will have difficulty in applying those controls to the trading systems, but as Mirae mainly focuses on equities, our implementation burden is much lower. Today, all our pre-trade risk controls are done in real-time, including automatic limits. Beyond this, we still have a layer of control in the trader on the desk.
Working with Brokers When discussing risk controls, it is important to mention that in Brazil all brokers employ significant risk controls on their side, to prevent them from taking on more risk than they can carry. When the brokers start to trade with the exchange, the exchange provides them with risk guidelines and limits. As clients of the sell-side, buy-side desks cannot exceed their assigned broker limits and their orders will be automatically paused if the broker’s limits are reached. The broker’s risk controls are complete; they will not take on risk. As a result, their clients do not have much help in implementing their own controls. This is exacerbated because a fund house may trade with many brokers – in our case we deal with 35. It is impossible to implement one solution per broker, so we rely on our OMS provider to connect with the brokers and to match up risk controls.
Timothy Furey, Goldman Sachs, Neal Goldstein, Nomura and John Goeller, Bank of America Merrill Lynch, shed light on the process of managing risk in electronic trading.
At the start of this year, FPL announced the completion of an initial set of guidelines, which recommends risk management best practices in electronic trading for institutional market participants. In the third quarter of 2010, FPL launched a group to raise awareness regarding the implications of electronic trading on risk management and to develop standardized best practices for industry consideration. Over the last few months, the group, which consists of a number of senior leaders in electronic trading from the major sell-side firms, has been working on developing this set of guidelines to encourage broker-dealers to incorporate a baseline set of standardized risk controls.
The objective of the guidelines is to provide information around risk management and encourage firms to incorporate best practices in support of their electronic trading platforms. In today’s volatile marketplace, the automation of complex electronic trading strategies increasingly demands a rational set of pre-trade, intra-day and pattern risk controls to protect the interests of the buy-side client, the sell-side broker and the integrity of the market. The objective of applying electronic order risk controls is to prevent situations where a client, the broker and/or the market can be adversely impacted by flawed electronic orders.
The scope of the particular set of risk controls included in the guidelines is for electronic orders delivered directly to an algorithmic trading product or to a Direct Market Access (DMA) trading destination. The recommended risk controls included provide the financial services community with a set of suggested guidelines that will systemically minimize the inherent risk of executing electronic algorithmic and DMA orders.
In what area are sell-side and buy-side firms’ risk controls most in need of improvement?
Timothy Furey, Managing Director, Goldman Sachs and FPL Risk Management Committee Co-Chair: One of the observations coming from the FPL risk sessions was that the buy-side and sell-side had really given considerable thought to their own individual firm’s risk controls. That said, both the sell-side and the buy-side should continue to focus on pulling together a standard, consistent base set of controls that their respective firms can reasonably implement. Therefore, it is more a question of standardization than a need for specific improvement.
John Goeller, FPL Americas Regional Committee Co-Chair and Managing Director, Global Execution Services, Bank of America Merrill Lynch: This effort was not necessarily to address an apparent deficiency in how the buy-side or the sell-side handles risk management, but to codify a set of best practices for all firms to use. It was generally accepted when we started this process that all firms implement some level of risk controls around their business. Our goal was to identify the most common ones and ensure that we have a base set of controls that all firms can implement.
Neal Goldstein, Managing Director, Nomura Securities International and FPL Risk Management Committee Co-Chair: It is important for the buy-side community to recognize that their efforts to implement risk management controls for electronic trading will be more effective when a collaborative effort is made with their sell-side executing brokers. For algorithmic and conventional (low frequency) DMA orders, the first line of defense should be the risk controls incorporated within the buy-side OMS/EMS. The most effective risk control is to prevent a questionable order from leaving the buy-side OMS/EMS. A specific factor that the buy-side should be looking at more closely is the impact a given order has on available liquidity. While the order validation employed by many buy-side clients accounts for notional value and order quantity, another factor that needs more consideration is the Average Daily Volume (ADV) during the trading interval. Creating an order to trade, where the volume participation rate may exceed ADV for a given interval, can have significant adverse impact on execution price and algorithmic performance, particularly for illiquid names.
What role, if any, should the exchanges play in implementing risk controls?
John Goeller: Most exchanges have technology solutions (in certain situations it is mandatory) around risk management. In some cases, these tools are optional and only work when accessing a particular exchange. Regardless, if a firm is utilizing exchange provided tools, home-grown, or vendor-supplied, they can still leverage our efforts to understand whether their tools are implementing industry best practices.