Six months after the event, we can reflect that the CHF move in January has proven with a real life example that prime brokers may be exposed to risks way beyond their own capital adequacy through the credit lines they provide to their customers. In a two-part review of a solution which may help some brokers to attain better risk management, Finance Magnates explores one of the solutions on the market designed to do just that.
On January 15th, the SNB shocked the world by scrapping its EUR/CHF floor of 1.20 Swiss francs to a euro. The aftermath of such a move left catastrophic devastation in the wake of brokers such as Alpari and Boston Prime filing for insolvency, while major firms such as FXCM and Citi taking losses of $225 million and $150 million respectively.
Numerous other brokers, namely those who had been operating with a true agency model, took massive hits to their balance sheets due to the unprecedented moves in a major currency.
Some surviving brokers, such as Interactive Brokers and IG, have chosen to go after negative client balances while others such as OANDA and Dukascopy have chosen to forgive. But, did this mean that some firms were better at managing risk compared to others, or have firms simply been lucky or unlucky during the situation which unfolded?
Stringent risk management has been the cornerstone of the FX industry
The Vice President of Institutional Sales at Dubai headquartered Fortress Prime, Nick Kundani, shared with Finance Magnates, “Stringent risk management has been the cornerstone of the FX industry since its transition to the wide market. With trillions in volume traded everyday on the FX markets, it is a focal point of all Prime brokers to adequately manage the risk of the flow that occurs on its books.”
He gave an example of how exposed a prime broker can be to the credit lines which it provides to its customers, “A $1 million client with 10 avenues of access to liquidity can easily expose the Prime broker to a $1 billion in open exposure. In the OTC FX market, most risk management solutions have been post trade focused. The major issue with post trade risk management solutions is the lack of real time monitoring of credit and margin requirements and exposes the Prime brokerage to massive exposure due to software glitches, rampant algos and flash crashes such as the one we have seen in the CHF crosses.”
Fluent Trade and Fluent Prime
Fluent Trade Technologies was founded in 2009 as a technology service provider for a group of hedge funds. The firm first serviced only the buy-side of the market, which brought some advantages into the construction of its sell-side products for prime brokers. Since Fluent Trade has been on the trading side for the past six years, the company decided to leverage its expertise into the other side of the foreign exchange trading business. By developing Fluent Prime, during the past two years the company has aimed to address the risk management worries of prime brokers.
But what is risk management, what are its aspects? According to the Founder and CEO of Fluent Trade, Gil Neihous, “Since each venue has different risk methodologies, we need to have an aggregated view of risk – both on the broker’s and the client’s side. There are few types of big traders on the market who are prime broker customers – those who are developing everything in-house and the others, who are buying third party software.”
With these being the two main options that traders have, Fluent Trade unifies these two options because of the software infrastructure made available by the company. Clients of Fluent Trade have the ability to build on top of the products of the firm’s solution product suites by adding their own code.
Fluent Trade aims to solve prime brokers’ credit exposure issues. Existing risk management methodologies are completely based on post-trade venue ticketing – without real-time credit aggregation, there is no way to block a rampant algorithm and no proven kill switch to stop all or select trading. At the same time, instead of traders spending millions of dollars to solve hosting, connectivity latency, and certification problems over and over again, they can focus on their core business – trading algorithms, market analysis or strategy optimization.
The company started providing its services primarily for high-frequency trading (HFT) clients, but today 90% of the firm’s clients have nothing to do with latency, with the focus shifting onto efficiency. The company offers hosting capabilities in Tokyo, Hong Kong, London, New York and Chicago. In addition, Fluent Trade has cross connects to over 90 venues worldwide – banks, ECN market makers, hedge funds, etc.
Market structure failures such as the “flash crash” of the CHF will heighten interest in pre-trade risk controls
As risk management has been highlighted by recent developments as the key element protecting a broker’s business, Fluent Trade has delved into the industry to provide a tool for prime brokers to protect themselves from extraordinary events like the one which occurred on the 15th of January.
As we have seen, risk management flaws can erase a year’s worth of profits (or more) very quickly. Market conditions have proven that risks can occur not only from positions that one holds, but also with credit lines associated to clients, as has been the case with prime brokers.
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In the words of Mr. Kundani, “Market structure failures such as the “flash crash” of the CHF will heighten interest in pre-trade risk controls and have clearly created a requirement for market participants and market operators alike to bolster their risk management capabilities. Market participants today must put processes in place to ensure that toxic flow is prevented from entering the marketplace to ensure market integrity. While organizations know they need these added controls, they know these controls can elevate operational cost, and can impact latency, affecting execution speed and quality.”
In the World of Prime Brokers
Fluent Prime is a risk management suite, with the software having a number of different risk and behavioral rules which are calculated within 1.8 microseconds in order to deliver strong a solid solution for prime brokers. Those include, but are not limited to number of orders per second and profit and loss – if a certain threshold is reached within seconds, positions are going to be closed automatically. The brokers are able to activate or deactivate rules at their discretion.
Looking at the world of prime brokerages, we have a very fragmented market across different major venues. Therefore, when a client wants to have proper access to liquidity, he needs access to at least 10 good liquidity providers. The business of prime brokers is one of the oldest in the industry, and as such the philosophy and the entire infrastructure is based on a post-trade mechanism – clients get credit extended to them based on their balance and not depending on the riskiness of their strategy. The higher the balance, the more credit a client can get access to.
The big downside here is that prime brokers have the ability to understand what the client has done only after the trade took place. This results in a big issue in the market – today’s credit allocation is static – when an account is opened, certain credit is allocated to it, regardless of whether the client is trading or isn’t, regardless of the strategies he is using, and regardless of his trading style. In current market conditions, with very few large banks operating in the space it can be a problem.
On the other hand, we have clients using their own bank credit relationships to trade. There are two risks to the prime broker – if something goes wrong, the bank is still going to go after the broker and on the other hand, the broker can not control what clients are doing with the credit lines they are presented with. If the prime broker relies on its liquidity providers to stop out certain trades, it’s going to take them a long time to do that, as we saw on January 15th.
Due to the very fragmented market, the risk protocols and risk definitions between different venues are not the same and this results in a very complex fragmented risk structure. From a prime broker’s perspective Fluent Prime provides a solution for prevention of risk, not its detection, which is the common practice in the industry. This is the key difference between what the company is offering – automatic prevention of risk situations taking place as an alternative to the post-trade mechanisms which provide a detection ability only after a human hand has to take action and apply certain changes.
Fluent Prime provides a dynamic credit control and credit utilization in real-time, with latency virtually non-existent. In addition, the clients can easily customize the software to their needs. Fluent does not have visibility over what their clients are doing, and Fluent Prime is run on the client’s own server. This is a crucial aspect of the solution and puts brokers on par with the banks which have spent millions of dollars to build their own risk systems. What Fluent has done is to build a bridge between the risk rules from the prime broker’s server and the client’s server. The trade is then checked on the client’s server based on the settings which the prime broker has populated into the client server.
The concept is simple – the banks have all the tools at their disposal, but the way the market works today is the order goes to the venue and then it goes to the PB, here the PB has the ability to sit within the client without sacrificing speed, because the orders do not have to travel between the prime broker or the bank, all of the information is on the client’s side. That said, there are downsides to the solution since prime brokers using Fluent Prime will have to convince their clients to use the trader solution of Fluent Trade.
Mr. Neihous explained, “Fluent Prime is unifying the risk between market makers and market takers. The solution gives control over open orders, net open positions with the PB in control. The prime broker today has no idea about how many orders have been sent by clients to the execution venue. The solution is supporting Java, C++ and .NET and supports reconciliation with technologies like Traiana.”
Fluent Prime essentially ensures that the prime broker knows that clients will not be able to breach certain preset limits, while the customer’s intellectual property will remain private. Fluent Trade offers an end to end API, which ensures easy integration between the prime brokers and the trader’s infrastructure – it only takes a couple of weeks to build the whole system.
Mr. Kundani explained, “Fluent Technologies appears to have created the technology (Fluent Prime) that implements pre-trade risk controls without affecting latency. With a multiple level hierarchy of pre and on trade risk management rules and its proportionate enforcement on net positions, credit risk and exposure, Fluent Prime inspects and evaluates orders in real time and blocks violating orders.
While there are various pre-trade risk management systems out in the market such TMX and Celoxica, Fluent Prime’s risk modules are an integral part of the system rather than an add on module which coupled with the ability to have risk engine run on the trader’s machine does not add additional latency to the market.”
Explaining the nature of pre-trade risk management, Mr. Kundani said, “The futures and equity markets implemented pre-trade risk management solutions to avenues such as the NASDAQ after the flash crash of 2010. The markets however are a fickle mistress ever-changing her ways with different reactions to different events at different times. While a prime brokerage can implement better and faster technologies to anticipate events, ever so often we come across an event that changes the structure of the market and requires a new idea to manage the market risk. The only thing we, as market participants can do is to implement the best technology and solutions and navigate the risks to the best of our abilities.”
The second chapter of this product review will be published shortly in the Institutional FX section of Finance Magnates.