By Brian Ross, CEO, FIX Flyer
Pre-trade risk management is not new to the sell-side or exchanges, but the way it is implemented continues to evolve. Since the Market Access Rule 15c3-5 was enacted, the solutions that were implemented were done on a pre-trade level. However, the complexities of the market today and the compliance within the spirit of the rule call for improved technology for both pre-trade and post-trade surveillance.
The Flash Boys book by Michael Lewis and the subsequent debate highlight the fact that investors have lost faith in the integrity of the markets within and beyond the borders of the US. But investors have not given up completely. They want the trading community, made up of themselves, brokers, exchanges, dark pools, and regulators, to offer solutions for keeping them safe.
Institutional investors are concerned with market participants who leverage predatory trading tactics resulting in skewed pricing and returns. Being able to monitor and stop this kind of abusive behavior is important. But managing risk is more than just setting limits and waiting for an alert to be triggered, like a speed bump that lacks awareness of previous patterns of information. An effective trade surveillance platform detects deviations from established trading patterns and possible manipulative trading.
Compliance officers and trade support desks must be empowered with tools to effectively monitor for suspicious activity in near real-time. In today’s high-volume trading environment, trade surveillance tools must scale extremely well in order to be effective under unusual, suspicious trading conditions.
Investors expect that brokers, exchanges and regulators are working together to create a fair market with equal access. And the brokers, exchanges and dark pools need to prove to all investors that they are doing everything they can to provide a comprehensive risk management program. And all of this must be done while the buy-side develops ever more sophisticated technology to capture alpha.
FIX facilitates a holistic view of risk
Up until now, pre-trade risk management has been streamlined for equities. We are moving beyond this one dimensional approach. Today a broker needs to aggregate exposure across multiple asset classes – meaning equities, options, futures, fixed income, commodities, and currencies. Derivative markets face the same fundamental issues as equity markets, such as risk and orderliness; the technology can be extended with a minimum investment. In the US and other developed markets, regulation and oversight of derivative markets is less mature than that of equities markets, making pre-trade risk management and trade surveillance systems a critical concern for brokers, exchanges and regulators. For example, derivative products continue to shift to exchanges, such as certain swaps to Swap Execution Facilities (SEFs), pre-trade and post-trade risk management must be put in place.
FIX makes it possible to get a single view across clients and asset types. Although the characteristics of the various asset types can be very different, the workflow for orders across the different asset types is very much the same. FIX is the lingua franca for trading across asset classes, simplifying risk management across asset classes and facilitating a holistic view of trading activity. A FIX-based platform can provide a centralised view of all of a counterparty’s trading and positions in real-time. This protects the broker from a client exceeding its financing intraday or a client from an excessive margin call. The broker is also able to use this consolidated view to manage other risk and compliance related items, such as corresponding clearing.
FIX is effective at allowing different payloads within the same workflow, dealing with all of the idiosyncrasies at many firms, and allowing for nuances in the data. While that variability can sometimes complicate the normalisation of data, imagine how much worse it would be without FIX.
A big moment in understanding pre-trade risk came when the FPL Americas Risk Management Working Group released the Recommended Risk Control Guidelines in June of 2012. The document targeted brokerage firms in the US that were looking for best practices and a common nomenclature. Since then, we successfully introduced it into emerging and frontier markets and it has accelerated the dialogue around risk for both the brokers and exchanges. In addition, it allowed vendors like FIX Flyer to educate and engage this new community who wanted to be compatible with global standards. This is an excellent example of how the FIX Trading Community has gone beyond data definitions and protocol specifications into real business workflow.
Integration is easier with a properly defined FIX interface. FIX is common all over the world. Implementing pre-trade risk workflow when the local OMS can accept the workflow in FIX makes integration standard. For example, we have integrated the same core logic in Mexico and Turkey and even though each market is different, each with their own regulatory rules, we can provide a workflow, data dictionary and an integration that works. New pre-trade risk DMA gateways along with critical trade surveillance technology let local brokers provide a great experience to the users and lets the emerging and frontier markets plug into the world’s capital market systems.
It takes many to create a trusted global market.
All participants are responsible for risk management and market surveillance because everyone has a stake and everyone shares the same goal.
Trust in markets comes from transparency and mutual alignment of individual interests. For example, an institutional buy-side trader trusts that markets are fair and brokers act in their interests, or they will take their business to someone who does. When discussing pre-trade risk with a large broker, we have been told “If all of my clients were Fidelity and Wellington, then we would not need risk controls. When we attract business from other firms, we need to keep it safe for everyone.”
If participants don’t help ensure markets are effective, the result will be more heavy-handed oversight and regulation. We are in a time where there is a lot of focus on HFT. Failures in electronic trading can be attributed to poor programming; a lack of rigorous testing; or people deliberately programming their systems to gain an unfair advantage. Those in the latter camp are just using the markets as a tool – if that tool is unavailable then they’ll find another. The fact is that the tool is not the problem, but the people are. A single counter-party can wreak havoc with a system malfunction or questionable trading behaviors, causing investors to lose trust in the market.
As we described before, the global capital markets have become complex and interconnected as technology has reduced the barriers to trade in local markets and across global borders. Exchanges and governments in frontier and emerging markets are eager to attract capital. But they are looking to the developed countries to use the same general structure and understanding of risk controls. Thankfully, new technology is being applied to shore up the integrity and performance of the global capital markets.