The risk management of electronic trading (e-trading) has rapidly matured over the past decade as the understanding and impact of e-trading risks intensifies and attracts more concentrated regulatory focus. However, risk frameworks are often disconnected, siloed and inefficient across the lines of defence. Without dedicated attention, e-trading businesses remain open to the risk of operational incidents, disorderly markets, and regulatory scrutiny – with the potential to eradicate profitability attributed to technological advances.
In this paper, we explore the challenges firms have faced in managing their e-trading risks, and the ways in which they can strengthen their frameworks, focusing on best practices and areas for improvement. We explain why committing resource to stepping back and reviewing their entire front to back framework, can protect the firm from risks materialising in increasingly uncertain and volatile markets.
The automation of trading in financial markets has developed over the past decades from basic pricing calculations and order routing to more complex investment decision and machine learning techniques for seeking alpha. Firms now have large inventories of trading algorithms across all asset classes but have struggled to standardize the implementation of risk management techniques across their e-trading businesses.
Initial regulatory scrutiny and internal risk management was light touch, with the general treatment across the industry focusing on e-trading as ‘just another method of execution’. However, as techniques began to be comprehensively adopted by regulated firms and events caused instances of significant market disruption, regulators across the globe began responding – setting expectations as to how firms should manage the risks inherent in electronic trading activity.
As the algorithmic capabilities of firms have developed swiftly during the recent surge of automation efforts, regulators recognised that prescriptive rules would quickly become outdated and therefore set ‘expectations’ around how firms should approach the challenges. This has left requirements open to interpretation – resulting in a wide degree of implementation maturity across the industry.
Risks posed to e-trading firms
Regulatory expectations only exist because firms are exposed to tangible risks through engaging in e-trading. The onus now is on firms to assess the level of risk being taken as part of an embedded process, specifically for their e-trading businesses, and to develop a commensurate framework in order to control risk.
Any good risk management framework needs clear ownership and responsibilities – documented and managed through an effective Target Operating Model. E-trading is no different, though it has been a difficult area for many firms to tackle. Expertise has typically sat within the business and first line of defence (1LoD). However, the need for independent oversight has been a challenging path for firms who lack the expertise to effectively oversee and provide adequate challenge from the second and third lines of defence (2LoD and 3LoD).
E-trading therefore requires a collaborative approach to develop an effective risk management framework. We will explore later how a robust first line controls framework can be leveraged by the second line to monitor the risks being run. Furthermore, adapting their existing risk management frameworks, firms have been able to look forward towards what a future-proof, nimble framework might look like – one that maintains the core principles of risk ownership and independent oversight, but that also does not slow down the trade order flow and allows e-trading businesses to remain competitive in a crowded market.
We have broadly broken down the approach into the following key constituent parts of the front-to-back risk management framework:
- RISK GOVERNANCE
- RISK TAXONOMY
- RISK MANAGEMENT
Please download the full white paper, to read our insights on these three constituent parts: