We can all appreciate the saturation of information on MiFID II, Dodd Frank and regulatory compliance, which has been filling the market space and still continues to do so with some alacrity. However, the key point to remember through all the noise, is that it is the trader who ultimately matters. It is of no consequence what he or she looks like or how they trade. What is crucial to appreciate is that it is he or she who pays the bills at the end of the day.
We are all concerned with being adequately protected and covered in the event we have a problem. We need constant reminding of why we have regulations and how they add overall value. Unfortunately, the reality is that markets are abused by individuals or corporations through poor management, which has resulted in many honest participants losing serious money. Regulations are based on experience and not invention, and like everything, the balance between cost and benefit needs to be assessed. However, much to their detriment, many believe that the costs outweigh the benefits.
In discussing abuse, the topic of HFT (High Frequency Trading) and the risks posed to our world, have been rehashed many times. Before HFT became a headline ‘problem’, machine automated market-making by trading firms was improving market depth enormously. The arguments favouring the benefits of adding automation to trading have been sparse. It is too easily forgotten that the earliest automated trading engines are the reason we have liquid option markets with the most competitive spreads today, that years ago were unimaginable. New markets and products abound, the demand remains strong.
None of these can start without automated market-making and the trader commitment that this entails. It also means that someone starting out can commence trading and become a successful trader safely. In the good old days, when small or independent traders were made to play second fiddle to the large institutions, they would get filled and stopped out, wiping out all their cash and then some, before they really got going. Long before it was a requirement to monitor Initial Margins (IM), firms begged for IM based trading power to remove the risk of overleveraged traders blowing themselves and their clearers up. Most used to think this was impossible in the ‘at-trade’ world, never mind the ‘pre-trade’ one. In this particular case, the pioneers who implemented these systems in the post 9/11 chaos, have pre-empted the regulators. Sensible business practices drove investment in innovative solutions, in order to ensure survival. The same changes are occurring in the clearing world, with a move to real time margins and informing customers in real time.
Regulations level the playing field
So, all participants need to be monitored accurately and effectively – it’s not just about alerting the participant but also intervening if necessary. Smaller accounts are better protected. Speculators can enjoy easy and similar access - give or take a few microseconds (or is it nanoseconds now?!). As a professional trader, big accounts cannot be cavalier with unfettered access (as in the past) and in most cases trade directly with those small accounts with no negative impact for either side. In the bad old ‘pre-automation’ days, smaller orders were parked on the sidelines, while out of necessity, institutionals traded with institutionals only.
Monitoring Real-Time Now: A benefit to all?
Knowing what was happening went from knowledge about yesterday, to earlier today and finally to now. Knowing about the future - well, that’s a tough one….for now at least!
Data flows at break-neck speeds, both in volume and reliability as never before. The costs of managing and implementing systems to control them, are a tiny fraction of what they were 5 or 10 years ago. Cheap? Not yet. However, in the multi-million $/£/€/¥ world where medium to large trading and brokerage conglomerates operate, this becomes more of an affordable norm.
Also, valuation is moving from a singular ‘Mark to Market’ science to an artful predictive skill – based on mathematical models. This is all based on statistics with every known deviation thrown in, in the hope that all eventualities are covered… within VaR (Value at Risk)? Maybe. But, clearing houses have managed to overcome pretty much every kind of disaster thrown at them. How? They have built their own risk models based on estimations of Initial Margin requirements. This is based on instrument and portfolio (Span and TIMS and now more complex variants, which also include VaR such as Eurex Clearing Prisma) as well as experience. Today, every participant has funds in place to cover almost all unexpected events, coupled with systems to enable unimpeded market access to adjust exposure within seconds of such an event.
Both Initial and Variation Margins should not be viewed as an alternative but as primary and real-time risk measures. Whether absolute or leveraged, these need to be known before and after each order is placed. It may seem obvious, but why? Absolute spending power is either an extremely accurate control or a very clear guideline. In the first case, you have no need to worry about the trader overspending – as long as the system has been set up with some intervention in place. Either a person is charged with reducing positions in the event that Variation Margin has eaten all the currently available cash in excess of required IM. Or, a machine is pre-programmed to do this task in a fraction of a second for IM to be released. In the latter instance, the utilisation generates awareness through alerts or a combination of alerts that pre-empt any problems.
These systems are seen to be in the hands and under the control of the market access provider. Increasingly, the buy-side trader wants to have the same or tighter controls and be able to measure the ‘Riskiness’ of a position (independently of the broker, individually and also collectively as part of the group or firm’s risk portfolio) so they can plan their own disaster recovery strategy. After all, they are capable of ensuring business continuity in systems and software as well as being the experts able to best assess liquidity and position creation/destruction. Surely, therefore they are the best equipped to implement an orderly withdrawal, should the position prove to be too dangerous?
Self-controlled and dynamic leverage management is indeed the answer. The same systems used by the market access provider can be implemented by the trading firm that would also enable mutual agreement about values in a situation at stressful times. Of course, many systems are already independently implemented, built in-house or handed down by the clearer. However, in the case of the multi-broker client, the disparate systems would not be necessarily beneficial. Instead, a system that is a real time reflection of actual margin commitment across the entire trading book, using real Initial Margin values and Variation Margin, has alerts set to monitor a multitude of important limits and values to keep the trader informed, is essential. These are necessary components in our arsenal to protect us in an increasingly complex marketplace.
This article was authored by Alex Lamb, Head of Marketing & Head of Business Development Americas at The Technancial Company.