Barrier to Entry: Buy-side Pre-trade Risk Controls
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.
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.
The ideal situation for the buy-side should be to have pre-trading control on their side, not the brokers’, even if they do not build it themselves. The brokers’ concerns are with their limits from the exchange, and they are less focused on our limits. We have to develop the control for each product ourselves. In Brazil, margin requirements come from the broker, but they are derived from the limits set by the exchange, based on their stress models and movement fees. Many of the position limits on the sell-side have internal controls for each fund house, whereby brokers give limits based on the fund’s assets under management.
Algorithmic Order Flow
Here in Brazil we have many algorithmic funds or quant funds that are reviewed on a weekly or daily basis. By way of example, we had a multimarket fund with some quant strategy that used an algo to select its asset allocation, but the algo was only designed to run once a week. We do not have much in the way of HFT mainly because of the way these algos are designed in Brazil. Many of the brokers with HFT trading and related algo products to offer to investment managers (essentially, the traders who are familiar with the current liquidity profile) also know it will be almost impossible to get in at this stage with a good result.
When the circumstances are right for increased HFT, we do not expect to have to change many of our risk controls because we have already made significant investment in pre-trade controls. The fund houses with hundreds of funds, however, may find it more difficult.
Our risk controls are mainly focused on the transaction, market share and price movement. If a trader creates an order that is going to be 50% of the volume in a certain stock, then we will block it. Similarly with ‘fat finger’ trades: if a trader attempts to buy more than they have bought in the last year, then again it will be blocked. We have two kinds of warnings. The first is a caution, which requires a confirmation and the second stops the order because it is incorrect, either because of price or market impact. These risk controls are specific to the buy-side because often they are related to the makeup of a fund.
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