Regulators have laid down the law as to what they expect of broker-dealers in terms of pre-trade risk controls for both high and low touch trading.
MiFID II in Europe, the Market Rule in the US and similar regulation elsewhere spell out the checks and controls that organisations must have in place to monitor orders and trades and prevent errors and market abuses.
Recent hefty fines dished out to organisations that have breached requirements show that the regulators mean to apply the law rigorously.
But it is not only pre-trade that broker-dealers must have robust risk management. Position-keeping and profit and loss (PnL) systems should have the ability to group, slice and view positions in real-time with full auditing and trade history, including corresponding historical market prices and theoretical pricing parameters. Post-trade, broker-dealers must manage allocations, confirmations and fee calculations. Low touch generates high volumes of trade fills, so any system aiming to support integrated high and low touch business must have a middle office component that can scale to cope with the demand.
The regulations specify that, pre-trade, organisations must flag their algorithmic orders and have controls in place to block risky orders, ensure compliance with market rules and incorporate appropriate price discovery. The price element aims to ensure client orders are not entered at prices too far away from the market price. This could be due to a client error – so-called ‘fat finger’ – or malicious intent to spoof or layer the order book. It is the responsibility of brokers to detect and prevent such incidents as part of their mandate to ‘maintain an orderly market’. Under most regulatory regimes, firms must also include a ‘kill-switch’ to enable them to halt trading if they detect anomalies. Under sponsored access arrangements, brokers are ultimately responsible for clients’ trades and, therefore, must have pre-trade risk facilities in place to monitor and manage their clients’ exposures while not adding latency to trades.
Post-trade, a low touch system should offer a middle office component that supports management of trade allocations, confirmations and fee calculations, fully-integrated with other required third-party operational systems. It is not just traders that must make sense of high trade volumes and executions – the trades flow through a number of systems, so for low touch trading to be successful it is important to consider its implications in the middle and back office.
Low touch often generates a much higher volume of trade fills than high touch, which all need to be allocated to client accounts and booked out. This requires a middle office that can scale to higher message volumes, with tools – including automation – to aggregate fills in flexible ways to ease the book out process (this is particularly relevant for derivatives where there are often lots of small order fills that flow through the middle-office and clearing) and to reduce clearing costs.
In building a framework to support the convergence of high and low touch equities trading it is essential to have robust and scalable risk management and regulatory compliance facilities at all stages of the trading lifecycle. Along with the other key components of the trading framework, such as client connectivity and smart order routing, there are now vendor solutions for pre-trade, trade and post-trade risk and compliance elements.
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