Keeping Risk at Bay: A Systemic Approach

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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.

Neal Goldstein: The exchanges have already been playing a keyrole by implementing protection mechanisms, such as circuit breakerson individual securities, in response to excessive price moves. Having effective risk controls applied upstream by the client and the broker trading systems should effectively address a high percentage of risk management scenarios related to order entry. There are some obvious ules related to FIX connectivity, such as canceling all open orders on disconnect and the detection of questionable order entry patterns, that make a lot of sense to have.
Timothy Furey: The most important aspect of the work done thus far by the FPL Risk Committee is to point out that regardless of where risk controls sit, it is critical that we all work together to determine the most appropriate and most efficient ways to protect the marketplace.
How often do you think the ‘Pause’ option will be applied by brokers: hourly, daily, weekly? Also, how would a firm whose primary trading strategy is high frequency/low touch incorporate this guideline?
Neal Goldstein: For algorithmic order flow, I would expect that sell-side brokers will pause questionable orders a couple of times per day, particularly around ADV thresholds for illiquid names. Orders that exceed ADV thresholds are far more common than the conventional “fat finger” error, where an extra zero is inadvertently applied on the order quantity. The concept of pausing is more relevant to algorithmic trading, where orders tend to be larger and trade over longer horizons. For high frequency trading clients, where orders have typically smaller size and are highly sensitive to latency, any order that exceeds a broker’s risk threshold should be rejected immediately, rather than paused.
Timothy Furey: The notion of a “Pause” is not new in the world of algorithmic trading, where intelligently and effectively working an order may be part of a particular strategy.  Similarly, with orders that go directly to the market, if an agreed upon control is triggered based on prevailing conditions, there may be instances where rejecting or pausing the order may be the appropriate strategy.
John Goeller: Pausing orders versus outright rejecting them really depends on the business flow and the arrangement with the client. An electronic order that pauses after exceeding a threshold is typically an algorithmic order that is expected to be worked over a certain time horizon in an algorithmic trading engine. When an algorithmic order is paused, a sales trader at the broker dealer will assess the risk and either send the order on or call the client for further clarification. This is in contrast to a DMA order (low-touch, high frequency), which requires an immediate response, so most trading systems will reject the order when it exceeds a risk threshold.

What benefits might these guidelines confer on firms that incorporate them, either in terms of new opportunities or averted risk?
John Goeller: We view these guidelines as benefiting the whole market and all market participants, as it is an element of maintaining an orderly market. Preventing errors is a critical responsibility of all market participants.
Neal Goldstein: The most obvious benefit to sell-side brokers is reducing the potential for incurring financial losses as a result of trading errors or sub-optimal performance due to adverse market impact. The industry, as a whole, will benefit by improving investor confidence and protecting the integrity of our markets. For sell-side brokers, the ability to  demonstrate adherence to industry-wide standards for risk management practices will have a positive impact on sales and marketing with clients.
Timothy Furey: Helping to maintain a liquid and orderly market is certainly one of the objectives behind consistent risk controls and one of the goals of the FPL Risk Management Committee.
How will these guidelines evolvein the next months and years, and how is the Risk Management Committee shaping this development? Who else should be involved in the Committee to add to this discussion?
Timothy Furey: The guidelines are very much a work in progress as the FPL committee will continue to experience more industry participant involvement and, most likely, move beyond US equity execution.
John Goeller: The initial scope of these guidelines is focused on US equities, but the concepts should apply on a broader basis to other regions or asset classes. As the  document is currently out for comment, we expect additional assistance from the trading community and other committees within FPL to help enrich it for broader use outside of core US equity trading.
Neal Goldstein: The initial paper published by the FPL Risk Management Committee was a first attempt at effectively defining standards for electronic trading risk management. These guidelines will evolve as we continue to refine the model and incorporate feedback from industry participants. These initial guidelines are mostly focused on algorithmic trading of US cash equities. My expectation is that as we define a core framework, these guidelines will be expanded to cover global trading in multiple asset classes. While this paper was written by a sell-side working committee within FPL, the feedback we received from our buy-side counterparts has been invaluable. Going forward, we expect to  continue this collaboration. I also hope that at some point, we can engage the 3rd party OMS/EMS providers, who play a critical role in the electronic trading product space.
The risk management guidelines can be accessed via the home page of the FIX Protocol website www.fixprotocol.org.