Paul Hilgers, CEO, Optiver gave a key note speech focused on risk at the 57th WFE Annual Meeting, and here shares with us his viewpoint on new market risks and how to mitigate them.
Recent macro events like the Brexit referendum, and the French and US elections, showed that the integrity and functioning of markets remained robust and continue to function well in times of large re-pricing of assets.
But market glitches in the recent past, such as the US flash crash in 2010 and the unpegging of the Swiss Franc in 2015 have also led to market disruptions. This damaged public confidence in markets and called into question the role of exchanges and their participants.
Markets have experienced enormous changes over the last decade, both from technological and regulatory perspectives. It goes without saying that with new developments, new risks arise. There is no free lunch – no advancements without risk.
At Optiver we see two key risks to the fair and efficient functioning of the markets, and for us they are deeply concerning: Automated Trading Risk and Liquidity Risk.
Automated Trading Risk
Automated Trading Risk (ATR) is essentially mechanised trading gone wrong. It is our main concern from an internal risk point of view. Malfunctioning systems might not only cause a financial loss for Optiver, but could also create an adverse knock-on effect on the market.
ATR derives from complexity and change. It’s not just about algorithms. An algo is just one element of a highly complex automated trading system with hundreds of components that are all interconnected and often subject to daily changes. We will never be able to fully eliminate the automated trading risk – there is no silver bullet solution to these problems. Mitigation is the key word.
Rules-based regulatory requirements such as registering each algo (and all changes), or exactly prescribing specific testing requirements to individual modifications are questionable mitigating solutions. Principles and risk-based regulation allows firms to continuously improve their risk frameworks and technical solutions at best.
Optiver takes a structured risk mitigation approach for ATR, comprised of three pillars. Firstly, we look at our processes and governance. By clearly defining responsibilities and processes across trading & IT, the two functions remain distinct. In broader terms, our traders are responsible for the 'what', and IT for the 'how'.
Our second pillar is what we call ATR controls, or safety mechanisms embedded throughout the system. Think of pre- and post-trade checks such as frequency limits, price corridor controls, instrument integrity checks and independent real-time trade reconciliation. ATR controls are our most effective means to mitigate Automated Trading Risk.
Optiver asserts that exchanges should participate in the progress of this second pillar. Implementing pre- and post-trade risk controls to trading systems comes at a latency cost and market participants might be tempted to trade risk protection in favour of latency. So ideally, ATR controls should be implemented at the exchange level simply because exchanges impose protections impact all trading members equally.
The third pillar is risk culture, which underpins all other measures. Risk culture is often understated and hard to formalise, requiring a constant effort starting at the top of the organisation. At Optiver we try to foster a culture of humility and openness. If something goes wrong, we openly discuss what circumstances resulted in rational people making mistakes, and how to prevent such mistakes going forward. We call these Blameless Postmortems.
Liquidity is the oil of financial markets. A well-functioning, efficient market cannot survive without it, but we feel that it’s at risk partly due to two regulatory developments. First there is leverage ratio for banks. The capital requirements caused by the leverage ratio have increased dramatically and changed the economics of clearing firms. The decrease in the number of general clearing members is likely to continue, which consequently increases the concentration risk at the CCP. The calculation methods for the leverage ratio makes it unattractive for clearing firms to take on new clients - especially market makers – due to the lack of netting possibilities.
In fact, the current model discourages market makers to warehouse risk and provide liquidity. This leads to market makers focusing exclusively on highly liquid products without taking positions overnight. The SA-CCR solution is supported by the industry, but disregarded by regulators and policy makers. If no action is taken, relying on the current model could result in the option markets’ demise.
Another concern is the trend towards privatisation of order flow. Privatisation diminishes the transparent price discovery function of public markets, and negatively impacts the execution quality of the end investor. Recent discussions in Europe about the Systemic Internalizer (SI) regime within MIFID II and earlier debates about payment for order flow are good examples of this.
Markets, regulation and technology will continue to evolve. Principle and risk-based regulation is absolutely critical to tackle new risks that come with progress. The right risk culture is also fundamental to encouraging good risk behaviour. Market operators, regulators and participants should continue to engage in an open dialogue to safeguard the integrity of our markets and to promote trading in fair, efficient and well-functioning markets.