As black-box trading increases, hedge funds are executing orders at a rapid pace by drawing on their credit relationships with prime brokers. But, are prime brokers and clearing firms - which lend money and clear and settle accounts for hedge funds and proprietary trading groups - seeing the true picture of their clients' intraday risk exposure?

Hedge funds borrow money from prime brokers under margining agreements, which require the hedge funds to deposit cash and securities as collateral for trades. But, with prime brokers trading on different electronic platforms and choosing multiple executing brokers - for lower commissions, international expertise and/or more effective algorithms - the back offices of the prime brokers may not be picking up all the trades until the end of the trading day.

Electronic trading poses a challenge to prime brokers because hedge funds are trading anonymously through direct-market-access (DMA) platforms. Unlike the old days - when a buy-side trader or hedge fund called the sell-side trader on the phone to provide verbal instructions, which provided a safety check, - today, buy-side firms and hedge funds rent the broker's pipes or infrastructure to get the best execution across multiple venues.

According to a recent report by The Tabb Group, "Managing Risk in Real-Time Markets," as black-box trading and DMA trading increase, clients may be placing orders faster than their clearing firms and prime brokers can monitor the risk. If a hedge fund uses multiple executing brokers that supply their own DMA platforms, then the prime broker could be in the dark until the close of trading. The report suggests that prime brokers are incurring more risk because they are not calculating margin deposits in real time. Moreover, these so-called margin engines are not updated until all the hedge funds' positions are flipped to the prime broker at the end of the day.

"If you're executing with one broker and flipping to another prime broker, from the time that trade is taken up and accepted by the prime broker, somebody has to live with the risk," explains Steve Sanders, managing director at Interactive Brokers.

The situation becomes more complex as hedge funds expand their trading across multiple asset classes, such as fixed income, foreign exchange, options and futures. IT silos that exist with large sell-side firms may not share information in real time, and each desk may have a different risk model.

As a result of these gaps, the Tabb Group report calls for a new information architecture for fast markets that can update applications in real time from multiple sources using "push" technology. By tapping multiple sources of data, the technology would create a single "golden copy" of data to feed the risk, margin and accounting applications. This is faster than having several applications "poll" a single source for the same data, according to the report, which recommends that prime brokers either speed up transaction processing, limit clients' trading activity or assume additional credit or counterparty risk.

But clearing firms are reluctant to slow down their clients. "One of the things that can be a hindrance to black-box trading is latency," points out Harvey Cloyd, vice president at Wedbush Morgan Securities, a Los Angeles-based clearing firm and prime broker. According to Cloyd, who is in charge of the firm's professional trading solutions group and business development of its correspondent services division, Wedbush has grown its business by targeting black-box trading firms and broker-dealers with proprietary trading groups. The challenge for clearing firms is, "How do we allow black boxes to thrive in their world as efficiently as possible and at the same time perform the proper risk management that we need to do as a clearing firm and prime broker?" says Cloyd.

This is not to say that prime brokers aren't trying to track intraday risk. In general, prime brokers monitor risk through two mechanisms: buying power and margin requirement. Buying power is the dollar amount of trading a client is allowed to do based on how much cash is in its account. Margin is how much a firm is allowed to borrow the next day, based on the amount of cash and collateral (securities) that are on deposit with the prime broker or clearing firm. While DMA platforms can be programmed to monitor buying power intraday, the margin requirement is set overnight for the following day.

The problem with monitoring intra-day risk occurs when a client trades through different executing brokers, which could be a violation of its margin agreements with the prime broker, says Gary LaFever, COO and general counsel for FTEN, a risk management provider. "You have clients using multiple brokers, using different clearing firms, and it's, in essence, almost impossible to track what's going on during the day," he contends.