The Risks of Being Caught Naked

08-26-2010

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The Risks of Being Caught Naked

John Bates
08-26-2010 02:42 PM
According to the FT, the Financial Industry Regulatory Association is undertaking a �sweep� of broker-dealers that offer direct market access to high-frequency traders to find out if they have pre-trade risk management controls in place for their algorithmic customers. (Read the full story here: http://tinyurl.com/28rg287). Here at Progress Software we have been advocating the use of pre-trade risk management tools for some time. The prospect of High Frequency Trading (HFT) firms running trades directly through broker algorithms (naked access) to exchanges/ECNs without adequate supervision has always concerned us. Brokerage firms simply give their clients an exchange ID number, which the clients then enter into their algorithms so that they can trade directly with the exchange.

Regulators are right to be concerned. Unfiltered access to trading destinations can end up causing trading errors or worse. Anything can happen with naked access; from fat fingered errors, trading limits being breached, even fraud - all of which can cost brokers, traders and regulators big money.

Although the SEC proposed banning naked access in January, and the Committee of European Securities Regulators (CESR) is likely to follow in its footsteps, there has been considerable pushback from brokers and trading firms. They say that adding a pre-trade risk management step would cause a "latency hop" in the trading process, claiming it would make them uncompetitive. A layer of risk management often adds a third party into the mix, and - consequently - a delay.

But if everyone is required to add real-time, pre-trade risk management, then the competitive disadvantage is moot. The benefits of being able to pro-actively monitor trades before they hit an exchange or ECN far outweigh any microscopic latency hops in any event. The naked access playing field is hardly level. There are trading systems out there that claim to throughput a trade in 16 microseconds from outside an exchange's firewall, while exchange and ECN systems range anywhere from 250 to 700 microseconds (according to measurements by latency management firm Corvil).

Latency is clearly an important issue and complex event processing offers a solution. Brokers can achieve ultra-low-latency pre-trade risk management without compromising speed of access. An option is a low latency "risk firewall" utilizing complex event processing as its core, which can be benchmarked in the low microseconds. With a real-time risk solution in place, a message can enter through an order management system, be run through the risk hurdles and checks, and leave for the exchange a few microseconds later.

It is the ideal solution to a tricky question - how do I manage risk before my trade hits the exchange without compromising speed? The benefits are clear - a latency hop of a few microseconds not only saves money, it can also prepare your firm for the regulatory future.

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