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Risky Business

George Rosenberger, Managing Director and Head of ConnEx, ConvergEx Group, examines the current trends in risk management, and trade-away flow.
George Rosenberger_ConvergExWhat does the risk management landscape currently look like?
Over the past three years, clients and vendors have been increasingly focusing their efforts and resources on pre-trade risk management due to changing regulations. Broker-dealers that provide market access are required to have pre-trade risk/suitability checks in place for their clients. Inadequate checks can result in a dislocation in the market. Even worse, it can potentially result in financial and regulatory peril for brokerdealers. And, at the end of the day, broker-dealers may be responsible for orders that their clients execute, even if a client goes out of business as a result.
For the most part, executing broker-dealers have some basic pre-trade risk management checks in place. Many of them have their orders stop at the desk for evaluation. Others have more straight-through DMA-like order types, but have some pre-trade controls in place for aggressively priced or oversized orders. One segment that has been underserviced in this space has been correspondent clearing firms. Market Access Regulations have largely focused on executing broker-dealers. But, clearing brokers may also have a responsibility and be exposed to risk if they don’t have the appropriate pre-trade risk/suitability checks in place. Many correspondent clearing firms have risk settings in place with their executing broker counterparties, but not with their mutual underlying clients.
What is an existing scenario that would be of concern to clients/prospects?
Let’s look at the following scenario. ABC Securities is an executing broker for Smart Asset Management. Smart Asset Management clears with Wall Street Brokerage. ABC Securities and Wall Street Brokerage have a clearing relationship in place. ABC Securities delivers executed orders to Wall Street Brokerage via several industry utilities including 9a/9b, QSR and ACT. In certain situations, Wall Street Brokerage can set buying power/share size thresholds for ABC Securities in aggregate, but not for their mutual underlying clients. This puts Wall Street Brokerage at risk for client default. If ABC Securities does not have adequate pre-trade risk management checks in place, not only are they exposed as the executing broker, but as a result, Wall Street Brokerage is exposed. If Smart Asset Management sends an oversized order to ABC Securities and that order makes it through to the market, either because of weak or no risk checks, both ABC Securities and Wall Street Brokerage are then scrambling knowing that Smart Asset Management cannot cover the trade.
There is also a risk gap on the prime brokerage side. Prime trades, where an IBD introduces  a client to the clearing firm and that buy-side entity trades away, are not being appropriately managed to account for risk. Clearing firms need this information in orders to see the total capital usage for the IBD. Most clearing platforms look at the underlying accounts after the trade is booked. This is okay from a buy-side client leverage perspective, but does not provide the clearing firm with the full picture of the IBD’s capital usage. Risk systems clearly need to perform risk checks for executing brokers vs. prime brokers or vice versa in the near future.
How are practices shifting and adjusting?
Until recently, a firm like Wall Street Brokerage had little to no control of their clients’ traded away order flow, meaning that when the underlying client executed with a third-party broker-dealer either to pay for research or a soft dollar commitment as examples, Wall Street Brokerage didn’t manage that flow. There is a shift in the marketplace by larger clearing firms to change that practice. Increasingly, top clearing firms are mandating that clients who trade away go through the clearing firm’s pre-trade risk checks first. This gives each clearing firm control of orders on a pre-trade basis even though they aren’t executing the orders for clients. Ultimately clearing firms may be responsible for clearing and settling trades even if the order is oversized due to a fat-finger error on the client side. They could fail to deliver and that then also becomes an issue for the clearing broker.
Ideally, advanced pre-trade risk management systems can be put into place at executing broker-dealers as well as at clearing firms to set appropriate limits at the client/order level. Implementing risk controls at the FIX gateway level and in front of a broker hub is the optimal solution for all parties involved. It is tremendously difficult for firms to properly identify their underlying clients in order to set risk levels. Some of the more advanced risk systems identify underlying clients, but also offer brokers the ability to group like clients into risk groups (e.g. long-only clients versus hedge funds, stat arb clients versus manual trading desks, etc.). Audit trail is another critical component of risk. Understanding the needs of the broker-dealer community is very important. With that said, robust risk management systems offer reports and MIS packages that show which clients hit risk checks, which risk profiles were updated, and by whom and which new profiles were created by underlying clients.
Regardless of the solution chosen, broker-dealers are realising that it is much easier to implement a third-party risk management solution then try to build one of their own. In 2014, we expect to see two or three major clearing firms enter the pre-trade risk management space, and mandate that their clearing clients route through their risk gateway prior to the executing broker receiving the order. The space is certainly changing and industry players are taking notice and shifting priorities.
Do you see a lot of risk systems catering to this segment today?
No. In fact, this segment is very much underserviced in the marketplace. However, we are having more and more conversations with clients and prospects about it. As risk departments at larger firms expand their internal risk analysis, they are realising that there is serious exposure from trade-away business. Some solutions allow broker-dealers to combine trade-away order flow with order flow that routes through their execution systems so that they can have a more comprehensive view of the exposure by client, regardless of the executing broker-dealer.
Is it challenging for broker-dealers to segment their clients into different risk groups?
We constantly hear about the challenges that broker-dealers encounter when setting up the appropriate risk levels for clients. Good risk systems allow broker-dealers to group clients into specific risk groups. These risk groups classify and group clients with each other based upon their risk profile.
What is the next major enhancement coming to the risk software space?
In the next year, we will begin to see risk software that will capture and profile clients’ trading patterns over time. It will create benchmarks to allow risk managers to refine their risk settings for individual clients. These new trading profiles will make a risk manager’s job a lot easier. It will take the guess work out of what the appropriate buying power level is for a client or how a client uses their buying power throughout the day. It will also take into account clients who cannot short sell due to charter reasons, what the average trade size is per client and other relevant factors.
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