US regulator the Commodity and Futures Trading Commission (CFTC) took a new step in its strategy to reduce systemic risk on 1 October 2012 when Regulation 1.73 came into effect. This framework of rules set out where risk management must take place for buy-side firms’ order entry and the specific controls which clearing futures commission merchants (FCMs) and derivatives clearing organisations (DCOs) must use to control buy-side clients’ trading activities.
An extension to 1 June 2013 has been granted on two sections of the rules, limits for give-ups and bunched orders for futures and swaps, to allow the industry time to communicate limits to firms.
The new rules are part of the larger drive to make the derivatives market more secure by mitigating counterparty risk and limiting the negative effects of a default. Since 2009 the Group of 20 (G20) countries have been setting out regulations that will reduce the systemic risk that was found to exist during the early years of the financial crisis.
In the US the majority of these regulatory changes were set out via the Dodd-Frank Act in July 2010, while a raft on ongoing legislation in Europe is putting a similar regulatory structure in place.
They are establishing the market structure for derivatives trading via electronic platforms and the use of a central counterparty for clearing the majority of trades. The CFTC and cash market regulator the Securities and Exchange Commission (SEC) have been responsible for transposing the legislation into detailed regulation in the US, while the European Securities and Markets Authority (ESMA) is turning out technical standards across the Atlantic.
“In general, compliance has become a major driver for us - particularly, over the last year or so, starting with ESMA publishing its set of guidelines on systems and controls in an automated trading environment,” says Mike Forst, product manager at system provider Trading Technologies.
“For the ESMA Guidelines, we had a lot of the required controls in place, as we do now for CFTC Regulation 1.73. But, ensuring that our customers can be compliant with new rules as they arise is very important to us, and therefore adding new risk features has been one of our highest engineering priorities.”
Looking ahead of the trade
On 9 April the CFTC announced amendments to the Commodity Exchange Act which further supported the sentiment of the G20 to reduce systemic risk.
Under Regulation 1.73, which was added to the act, FCMs are required to establish risk-based limits in proprietary and customer accounts; screen orders for compliance using the risk-based limits; monitor clients for adherence to the limits during the day and night; conduct a minimum of weekly stress tests under extreme but plausible conditions across all positions that could pose material risk to the FCM.
In addition, they are required to evaluate the ability to meet initial margin requirements and variation margin requirements, the latter in cash, at least once per week. On a quarterly basis, FCMs must evaluate the ability to liquidate, in an orderly manner, the positions in proprietary and customer accounts with an estimate of the liquidation cost and conduct a minimum of annual tests on all lines of credit.
This is a significant workload for the firms but by determining where the responsibility of pre-trade risk checks lies, regulators are also determining how technology is structured. Forst offers the example of how firms offer sponsored access.
“Our customers that operate proprietary trading houses often run Trading Technologies’ software on their own servers,” he says. “They are being asked to provide the FCMs with exclusive risk control, and this presents some interesting challenges.
“Our software provides many levels of administration, but software alone can't guarantee that an FCM has exclusive rights to update limits when that FCM isn’t actually hosting the software.
“Depending on how literally these new rules are interpreted, you could see FCMs having to host more of their own environments. Or, you’ll likely see prop firms becoming non-clearing members and managing their own limits. TTNET is also an option that we offer our customers, whereby we host the software for them, on our servers. ”
Although the rules set out what risk measures the FCM must have in place, it does not determine how the measures must work, notes Hamish Purdey, CEO of Ffastfill a derivatives trading systems supplier.
“The rules haven't been prescriptive as to what level of risk management was required - whether pre-trade lot limits or full-span margin calculations,” he says. “With the additional eight months that has been granted to comply with the regulation I would expect there to be some variety in how that is interpreted.”
Jim Downs, CEO of trading system supplier Connamara Systems adds that this allows for some freedom in the complexity of technology used.
“It doesn’t talk about the manner in which they impose these risk limits, it’s more focused on when you must impose them,” he says. “There is flexibility in the way that you can impose particular checks just not in when they can be used. The rub, if there is one, is that now I have to tell someone how I am going about making these checks.”
However even determining when checks must take place will have an effect on the software that firms are using and the underlying architecture notes Forst.
“Historically, TT’s focus has been on performance. We’ve offered many pre-trade risk features, such as position limits per product. However, these have traditionally been configured on a per-trader basis, with the checks happening on the trader’s workstation. For most of our customers, this has worked very well.
“Now, the challenge our engineers are looking to meet is to build additional levels of risk checking, while maintaining [the] levels of performance. While we have always offered some group-level risk checking for traders sharing an order book, we have tried to steer away from risk checks at an aggregate level. There are always trade-offs when comparing additional risk checks against added latency.”
Downs observes that the acceptance of the need for improved pre-trade risk management and position management had been growing in the business following the flash crash on 6 May 2010 and the bankruptcy of FCM MF Global on 31 October 2011. However the post-trade element has not been such a source of concern.
“If you look at post-trade risk, FCMs have in place what works for them,” he says. “This rule will drive the advent of the enterprise risk system. That will allow them to make sure they have most sources of execution in one place, an order-based risk system, managing by exception not by looking at which client has the worst account.”
Forst adds: “Clearly FCMs are using multiple vendors for order entry and that creates some compliance and risk management challenges. FCMs need to have an understanding of their exposure across all platforms and vendor systems, and they need to manage risk at multiple levels.
“We are working with FCMs to provide them with the ability to configure multiple levels of risk checking, and also to easily integrate TT with their other systems.”