Risk management is essential for retail brokers and other financial
institutions. Exposure to market and or client risk can lead to systemic business risks if
the appropriate tools and processes are not followed. Here we outline the most important
ways to manage risk and how to execute at a business level.
Set up A books and B books
How client orders are booked in
the first instance is a key decision and has an impact on a good deal of subsequent risk
management strategies. Therefore, this needs to the first and possibly the most important
consideration. When a broker accepts a client’s trade, it can choose to internalise or
warehouse the risk, commonly referred to as being B-booked. This exposes the broker to
market risk as it is effectively taking the other side of the end client’s trade. It also
exposes the broker to counterparty risk. Brokers can manage risks associated with the B Book
by strategies such as internal hedging – matching of opposite orders submitted by other
clients – as well as spread variations. Booking rules can also be applied to fine tune the
risk management and tailor it, for example, market conditions, client type, asset class and
so on. Examples include increasing or decreasing B Book exposure limits depending on
volatility or changing limits during out of hours trading. A Book client orders, on the
other hand, are sent straight through to the market, usually to a liquidity provider or
multilateral trading facilities (MTFs). In many cases, brokers may find that operating a
hybrid A and B Book model is most effective. For example, warehousing or internalising risk
up to a given limit in an asset class, with a less or greater amount internal hedging
depending on the type of clients, assets and market conditions. Any orders accepted above
the risk threshold can be A-Booked, or sent straight to market. A commonly used process
would involve a broker identifying profitable traders, for example professional clients, and
routing all of their orders through the A Book, whilst funnelling the bulk of trades via the
B Book. Sound internal processes are required to manage this as client success can change
swiftly if market conditions alter.
Automatic hedging
Automatic hedging can help minimise human
intervention and deliver cost savings for brokers. Systems can be put in place, or
outsourced, so that exposure will be hedged automatically to market if risk parameters are
breached Orders can be hedged to the market automatically according to the percentage set in
the B-Book. Brokers can also look at position flat time configuration – client orders hedged
out after a certain time period, which can determine mark-outs of a client to optimise
profitability.
Net Open Position Limits
Risk can be controlled by
configuring maximum Net Open Position (NOP) limits across books, products and clients.
Ensuring NOP limits means you can control the amount of exposure at any one point. It is
possible to have different configurations across different B-Books or across different
instruments in order to manage risk more effectively. NOPs can be set for each asset class
with a cumulative allowance across the entire book. When the NOP allowance gets hit – either
in one asset class or across the entirety of the business- excess orders can either be sent
to market – A Book – or can be rejected. Underlying client NOP limits applied on an account
level can also be considered an effective risk management tool. NOP variations across
different groups of clients, such as Retail vs Institutional traders, should also be
considered. Alongside this approach, a complimentary policy of setting daily P&L limits
(within the B Book) can ensure a broker remains within its risk tolerance. Again, this can
be adjusted by client type or other variables to ensure profitability is maximised.
Customised Margins
A process of applying tiered or
customised margins is among the most common ways for a broker to control risk. Brokers can
customise margin requirements per instrument, for example in forex markets by increasing
margins for more volatile currencies such as the Russian ruble or Turkish lira. These can
also be amended by currency cross – eg a higher margin requirement for trading GBPJPY than
USDJPY since the former is more volatile. Similarly, brokers can have different margin
requirements by asset class, although in many cases this will be, to a degree, dictated by
regulators. Non-deliverable forwards (NDFs) may be set at higher margin requirements to
manage excess risk as these have proved troublesome products for many brokers. Margin, or
leverage, variations can also be applied across different groups of clients, usually Retail
vs Institutional traders. In Europe and some other jurisdictions, regulatory considerations
will be a factor in this calculation anyway. But it can still be left to the broker to limit
margins in some instances to better manage their risk. Open market hours margins vs closed
market margins can be used for managing risk for over weekend periods or during out-of-hours
trading on equity index futures, ie when the corresponding cash equity market is closed, and
liquidity may be lower.
Stress testing
An important process for good risk management
is stress testing – applying various scenarios and adjusting parameters of risk control to
forecast when risk limits could be breached. Although it is important to test multiple
scenarios, it is most important to focus on those which are likely and/or could materially
impact the firm. This means the broker can take action before the event, such as by
adjusting margins if needed (A book credit risk) or adjust its own NOP limits (B book market
risk) if a move/scenario could break its daily limits.
Outsourcing RM
A multi-asset
liquidity provider can manage all the risk on behalf of the broker. In addition to
best-in-class liquidity, Finalto offers risk management tools for brokers. This can be fully
tailored to the client, allowing the broker to continue to internalise some risk that it
feels comfortable with whilst outsourcing the rest. This can reduce the need for internal
dealing and risk teams to, for example, manage A and B Books.
Finalto Risk Management
Finalto offers brokers two customisable risk management products that can be
plugged in to existing systems to effectively manage a wide range of risks.
ClearControl
Liquidity aggregation and risk management
configurations
- Create and edit liquidity settings in real time
- Create and edit risk settings in real time
- Customise various risk control measures
- Currency netting
- Cross-margining
- Customisable risk actions to control liquidations
- Advanced B-book functionality to manage NOP, hedge strategies and liquidity management
- On-the-fly risk adjustments with automatic book reconciliation
ClearRisk
Monitor real-time client and hedge exposure
- Consolidate or manage multiple risk books
- Business intelligence – search and analyse trading patterns
- Real-time account information, exposure watch P&L, pricing and margin utilisation
- Multi-platform risk management tool (ClearPro/MT4/MT5)
- Manage risk for different geographical locations (LD4/NY4/TY3)
Several options to set up risk books
- Risk can be controlled by configuring maximum NOP allowances across books, products
and clients - Risk can be managed by 3 strategies: manually, trade aggregation or by applying a
hedge ratio - Exposure will be hedged automatically to market if risk parameters are breached
- Liquidity management can be applied to manage the risk book by applying replenishing
methods to mimic an STP book