Stephane Di Tullio, Barclays Capital:
"Some checks … take maybe a millisecond, but any level of complex computation can add a lot of latency."
Automated trading systems are hardly a new feature on the futures landscape, but the ever larger daily trade volumes generated in recent years means black box traders are increasingly making their presence felt. Derivatives exchanges have rapidly adapted to the demands of programme driven trading, first through greater volume capacity and faster response times, now also with colocation services and direct market access. Execution brokers and futures clearers too are developing their services and capabilities to handle the higher volumes, more sophisticated strategies and evolving execution trading preferences of automated traders. As well as providing more robust access to a wider range of exchanges, this means adapting risk management and monitoring techniques used to set margins.
Risk management has already changed considerably to keep pace
with the increasing frequency of automated trading systems,
according to Stephane Di Tullio, Director, E-commerce, Barclays
Capital. "Not so long ago, risk was being managed at T+3, let
alone T+1; now banks are managing risk within a tenth of a second
at worst," says Di Tullio. "The clearers that will be successful
are those that can manage risk by the millisecond, because
they're the ones that won't have to charge such a premium and
will be able to manage their true risk more efficiently."The risk
management challenge for clearers has steepened recently as
automated traders have increasingly taken up non-clearing
memberships of exchanges to trade directly. The risk management
filter or layer imposed by clearers on trades passing through
their exchange gateway takes little more than the blink of an eye
to process client transactions - but it is seen as a sufficient
encumbrance by lowlatency traders to prompt investment in the
technology required for direct connectivity to exchanges. "Some
checks, such as product validation, take maybe a millisecond, but
any level of complex computation can add a lot of latency," notes
According to Thomas Book, Eurex board member with responsibility for clearing and risk management, the shift to direct exchange connectivity is being led by firms - "typically hedge funds" - which employ trading strategies that exploit minimal market inefficiencies and as such are willing to accept the execution risk to cut trading costs to a minimum. "Their trading and/or investment strategies require direct exchange connectivity in order to achieve lowest latency in receiving market data and transmitting orders," says Book.
Karsten Schroeder, Amplitude Capital:
"It's becoming more complicated for the broker/clearer because their risk increases if they can't check the order beforehand."
Di Tullio asserts that many in the futures market are following equities in adopting 'true DMA'. "Any client that is speed sensitive, i.e. their trading strategies require the capacity both to see the dollar on the table and to grab it, will connect directly to the exchange to minimise the latency of both market data and execution," says Di Tullio, who sees parallels between the users of DMA in the automated trading environment and the floor traders on the traditional open outcry market. "In the old days, people paid a lot of money to be in the trading pit so they could be closest to the information and quickest to react to it. Pure DMA is the same concept." Although DMA accounts for an increasingly significant share of overall volumes in the futures market, it's not for all. "If you're a market maker trying to capitalise on short-term inefficiency, speed counts," says Di Tullio. "If you're hedging an exposure from your underlying business or placing a bet on the underlying stock, a couple of milliseconds doesn't matter."
True DMA - i.e. trades that flow to an exchange without the aid of a broker-supplied gateway - makes it considerably harder for futures clearers to monitor trading activity and therefore identify when agreed risk parameters are being breached, thus triggering a margin call. After all, how can clearers place margin calls on trades they cannot, in theory at least, actually see? "The third-party black box that makes a direct connection to an exchange - without any possibility of intervention - is the biggest risk that faces clearers today," says Alex Lamb, Senior Vice-President, Business Development, RTS Realtime Systems Group. "The automated trader who builds his own connection to the exchange should have some facility to deliver to his clearer a view on his positions, post-trade but in real-time so that the clearer can intervene, i.e. by disallowing a user i.d. at the exchange."
The futures clearer's balancing act is a difficult one to maintain in such a fast-changing environment. On the one hand, it has to cover its clients' positions to meet its obligations to the exchange; on the other it needs to understand its clients well enough to set appropriate boundaries on trading activities without imposing restrictions that drive business to competitors. And from Long-Term Capital Management to Amaranth, recent financial markets history is littered with examples of collapses that could have been avoided if clearers had not turned a blind eye to apparently profitable and successful trading activities. Risk parameters such as maximum intraday/overnight exposures and order size limits are a function of the clearer's confidence in the overall strengths and capabilities of the client, including not just an understanding of their trading strategies (a considerable task in itself ), but also operational risk factors such as the technology infrastructure deployed by the trading firm, its back-up capabilities and the processes used to exit losing positions in various market scenarios.
Leslie Sutphen, Calyon Financial:
"… clearers have also begun redistributing
Successful risk management relies heavily on strong client relationships, according to Karsten Schroeder, CEO, Amplitude Capital. "If as a broker/clearer you know a long-time client is diligent in its risk management, you can be flexible. In the end, it's important that the clearer has trust in what you're doing," he says.
A London-based hedge fund that uses automated models to trade in 24 futures markets globally, Amplitude Capital is one of many firms currently reviewing their connectivity options. As a directional trader that holds positions open over one-and-a-halfdays on average, trading in the region of 8-10 trades per instrument per day, Amplitude does not currently link direct to any exchange, but exchange connectivity is a key consideration when evaluating service from broker/clearers. "For us, there's three main points," says Schroeder. "First, we want a quick and stable connection; stability is just as important as latency because we're writing electronically to the interface of the broker and don't want any downtime. Second, we look for flexible IT solutions to help run our middle and back office fully electronically, for example automatic and frequent trade allocations to accounts. Finally, the ability to access a wide range of exchanges is also important," he says. Nevertheless, use of direct market access is not ruled out by Schroeder. "We could be interested in a quicker link to support certain strategies, but this would probably be through a thirdparty DMA provider, rather than directly, as maintaining the links to all the exchanges ourselves would be extremely expensive," he says. Schroeder acknowledges that the ongoing shift away from broker-provided exchange access presents a problem to clearers. "It's becoming more complicated for the broker/clearer because their risk increases if they can't check the order beforehand," he says.
Passing the baton
As more firms choose to link directly, futures exchanges are taking a new role in risk management by working more closely with clearers to share data on client transactions. "To ensure delivery of the high speed that clients demand, clearers have also begun redistributing market data directly from exchanges instead of from market data vendors," says Leslie Sutphen, Global Head of E-Brokerage Strategy & Implementation, Calyon Financial. "This requires an enormous investment in global support staff to monitor both systems and risk." For example, exchanges can send information on filled orders - sometimes known as drop copies - to clearers so that trading activity can be monitored in real time, albeit after the event. "The advent of DMA means higher volumes for exchanges, but it also means higher risk potentially and as such exchanges are working with the brokers to find new ways to manage risk appropriately in the new environment," says Barclays Capital's Di Tullio.
Eurex, the futures and options exchange, provides clearing members with real-time trade confirmations on a post-trade basis, both of their own business and that of their non-clearing members (NCMs), including all executed trades and all trade and position management transactions. A separate broadcast stream monitors all pending give ups and the respective claims. Eurex also offers a near realtime risk management service that breaks down the total margin requirement for each clearing member by margin class, NCM and account.
The exchange is upgrading the level of risk management information provided to clearers in view of the migration of high-frequency traders toward 'true' direct market access. Scheduled for launch in November, Release 10 of Eurex's intra-day risk management system will recalculate margin requirements in ten-minute cycles, rather than the current 15 minutes. "In the long run, we will move away from a batch-driven architecture to an eventdriven risk architecture, which captures position updates on an event-driven basis in real time without measurable latency," says Eurex's Book. The new release will also provide additional pre-trade risk protection to clearing and trading members. For example, clearing members can define various sets of order-related pre-trade risk limits for NCMs, including size, frequency, quantity and time interval. "These pre-trade validations are designed so as not to compromise the trading strategies and speed requirements of high velocity trading members," says Book.
A further new feature is that clearing members will be able to trigger a 'Stop' action on nonclearing members for use in emergencies. "Once the 'Stop' action is triggered, the Eurex system automatically deletes all open orders and quotes, prohibits the entry of new orders and quotes, rejects any trade or position adjustment transaction, and prohibits the approval of pending OTC and give-up/take-up transactions," says Book.
Although broker/clearers can access increasingly detailed, near real-time information flows from futures exchanges, there are obvious limitations: "If a trade is breaching the limit, it's already too late," says Amplitude's Schroeder. "This is where you have to make a compromise as a service provider because it's crucial for some clients to have low latency."
"Even with the most technologically advanced exchanges, there's always a lag in the supply of information," says Lamb of RTS Realtime Systems. "If a programme is trading 2-3,000 times a minute, and it takes 3-4 minutes for trades to feed through to your back office system, it might be 15 minutes before your risk systems identify a problem with a particular client to a risk manager." Moreover, information from exchanges rarely gives the global picture required to assess risk accurately. "The problem is that you don't necessarily see the order book. And for the exchanges that don't give you a global clearing feed, you have to somehow connect to all the applications the client is trading through," says Lamb.
So if real-time data from exchanges only provides part of the answer, how else can clearers keep tabs on clients that are potentially placing thousands of bets an hour via direct market connections? One approach of course, is for clearers to insist on a high equity-tomargin ratio - and there are plenty of firms making enough profits to put up the kind of collateral that will outweigh any potential intra-day exposure. Firms such as Amplitude that do not want to build their own exchange connections can feed order and fill data to clearers via third-party DMA providers using an API connection that can dynamically update the clearer's VAR system. But for those that 'dial direct', the clearer's approach is likely to remain one that is dependent on continued investment in risk management systems, a close relationship with the client and an understanding - even oversight - of its trading models. "If a black box trader says that they don't want any limits, the clearer might say 'If you want to clear through me, I want to know that there are rules built into your trading model that protect me as well as you every time it is deployed,'" says Lamb.
Alex Lamb, RTS Realtime Systems Group:
"Even with the most technologically advanced exchanges, there's always a lag in the supply of information."
Automated traders are thus engaged in a technology race with their clearers as much as their direct competitors. Futures clearers are well aware of the large volumes at stake and as such are spending to grow business while minimising risk. "We have invested in real-time post-trade risk management systems that send alerts out to support staff when certain thresholds are breached," says Calyon Financial's Sutphen. "Actions, such as cancelling orders and liquidating positions, can then be taken to prevent the client from exceeding risk limits."
In particular, futures clearers are responding to the expansion of higher-frequency automated trading strategies across multiple instruments and markets. "If I have a client trading on the CME and CBOT, I need to see exactly what they are doing to the millisecond; if I have a client that trades the FX futures against FX cash on the CME, I need to be able to see both positions to know the true risk. The worst thing you can do is make a risk decision without seeing the big picture," says Barclays' Di Tullio. While algo and automated traders might legitimately object to the latency that a clearer's risk management layer might add to response times, RTS Realtime Systems Group's Lamb says, the argument is less sustainable for strategies that trade across two or more instruments or exchanges. "By the time you've built the logic to send orders to two different destinations, the fraction of time that a risk management layer adds - or sending a drop copy to a third-party application - is negligible," he adds.
While traditionally clearers would have treated these as separate exposures, some have begun to develop the capability to net the risk to allow the client to trade larger positions without exceeding their risk parameters. Barclays Capital, for example, has developed a proprietary net margining solution that allows the bank to act quickly if a client takes one position in cash and then another in futures that increases his risk. This holistic view of client exposures across asset classes can also have benefits for the client. If, for example, a clearer charges 2.5 per cent margining in the FX cash market, the client pays $25m on a $10bn long position. And if he sells the equivalent value in futures to create a perfect hedge, and the margin is around 1.2 per cent, there's an additional margin of $12m. Viewed independently, these exposures add up to a total margin is $37m, even though the client is fully hedged. But if the true risk is calculated on a portfolio basis, the figure could be below $2m. While it is common for clearers to net client positions within a single asset class, a truly portfolio approach is much rarer, says Di Tullio. "Often there's no infrastructure for sharing risk across asset classes. But banks that don't address this issue right now will be at a competitive disadvantage," he says.