Wall Street & Technology is part of the Informa Tech Division of Informa PLC

This site is operated by a business or businesses owned by Informa PLC and all copyright resides with them. Informa PLC's registered office is 5 Howick Place, London SW1P 1WG. Registered in England and Wales. Number 8860726.


08:31 PM
Larry Tabb
Larry Tabb
Connect Directly

Risk in a Real-Time World

The world is getting riskier. Not only has geopolitical strife changed compliance risk, but new trading, governance and capital-allocation mechanisms are changing traditional risk measures as well.

The world is getting riskier. Not only has geopolitical strife changed compliance risk, but new trading, governance and capital-allocation mechanisms are changing traditional risk measures as well.

Not long ago, risk management was applied only to market risk. Firms analyzed convexity, duration, VaR and the greeks to determine how financial products behaved in relation to the market, to changes in interest rates, or to random global financial market shocks. From market risk, the industry moved to credit risk, and now firms are stretching these models again to manage operational risk.

But is that enough? To satisfy their customers' needs, firms are extending their infrastructures to enable customers to trade for themselves, providing trading technology known as direct-market-access (DMA), aggregation or execution-management systems (EMS) to clients. But as firms provide DMA to their customers, the nature of the risk the firms accept changes.

Firms' risk-management platforms are a patchwork of technologies and processes. Market- and credit-risk platforms are traditionally batch-based and supplemented by trading-desk alerts and management oversight. Traders and customers were given limits and were policed by trading and risk-management personnel. If risk levels approached preset limits, management stepped in and chided the trader or cut off the customer. Since all volume went through the trading desk, risk was fairly easy to monitor and rectify.

However, with the advent of DMA - and the proliferation of hedge funds that have the ability to use leverage, go short and develop black-box models - the way firms monitor risk needs to change. First, hedge funds can use cross-asset and cross-geography hedging strategies that tax traditional credit-management capabilities. Similar to clearing firms, prime brokers need to manage risk from an outside perspective. They need to analyze the funds' trading flow, strategies and risk across asset class, not just the amount of volume they are trading.

Second, many DMA orders bypass firms' trading infrastructures. Firms such as Lava provide their own technologies, connectivity and infrastructure to place orders using the introducing broker's identification or Market Participant ID (MPID). This way the buy-side order gets placed expeditiously and anonymously, and the broker gets the credit. While bypassing the trading desk helps hide customer order flow, it also bypasses firms' risk models.

Why should brokers care? Because brokers are responsible for settling, clearing and making good each and every trade executed with their MPIDs. What if the fund behaves irresponsibly? What if a model goes awry? What if someone sits on the keyboard? In a nanosecond, a huge order or wave of orders can be sent hurtling through high-speed pipes toward exchanges, ATSs or ECNs without the broker's knowledge or ability to stop it.

The broker may not even know these orders are being executed until hours later, when it may be too late. Gathering this information from an exchange or ECN is not easy, as our execution fabric is fragmented, heterogeneous and decentralized, and piecing together information from the multiple providers can prove difficult.

So, as firms transition their clients from relationship brokerage to direct market access, and change their trading from hands-on to hands-off, it does not mean that there is no risk - the risk just changes shape and size. While DMA may transition trading to the buy side, it does not transition the risk. As brokers look more like electronic service providers, firms need to change not just their tools and technologies, but their process and risks models as well.

Larry Tabb is founder and CEO of Westborough, Mass.-based The Tabb Group, a financial-markets strategic-advisory firm. [email protected]

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
More Commentary
A Wild Ride Comes to an End
Covering the financial services technology space for the past 15 years has been a thrilling ride with many ups as downs.
The End of an Era: Farewell to an Icon
After more than two decades of writing for Wall Street & Technology, I am leaving the media brand. It's time to reflect on our mutual history and the road ahead.
Beyond Bitcoin: Why Counterparty Has Won Support From Overstock's Chairman
The combined excitement over the currency and the Blockchain has kept the market capitalization above $4 billion for more than a year. This has attracted both imitators and innovators.
Asset Managers Set Sights on Defragmenting Back-Office Data
Defragmenting back-office data and technology will be a top focus for asset managers in 2015.
4 Mobile Security Predictions for 2015
As we look ahead, mobility is the perfect breeding ground for attacks in 2015.
Register for Wall Street & Technology Newsletters
Stressed Out by Compliance, Reputational Damage & Fines?
Stressed Out by Compliance, Reputational Damage & Fines?
Financial services executives are living in a "regulatory pressure cooker." Here's how executives are preparing for the new compliance requirements.