With Brexit fast approaching it is vital to ensure all systems and risk are appropriately managed to prohibit losses and maximise gains. Jeff Wilkins, Managing Director of IS Risk Analytics suggests ways for brokers to effectively analyse and manage their technology, liquidity and flow to ensure they are adequately protected should another flash crash occur.
The following article has been written exclusively for LeapRate by IS Risk Analytics (ISRA). ISRA provides risk management, hosting technology and institutional bridging services to foreign exchange brokers and specialises in revenue maximisation solutions. IS Risk Analytics provides a service for professional investors and is part of ISAM Capital Markets which also includes IS Prime and IS Prime Hong Kong.
On January 2, 2019, JPY depreciated against the US dollar by over 3% in less than 8 minutes. At the time, the incident was loosely connected to an Apple announcement regarding sales in China earlier in the day but many analysts have subsequently debunked this suspicion. The likely cause of the crash was a combination of the general increase in algorithmic trading volumes combined with extremely thin markets during the “witching hour” – the period between 5pm and 6pm NY time when US traders have left for the day and Asian traders have not yet arrived. At this point, liquidity is lower and market reactions can be massively exaggerated.
The current Brexit situation is a good example of a time when brokers can, with some degree of accuracy, predict where and when volatility will occur. This means they can prepare for it, unlike the yen crash earlier this year or the SNB in 2015.
Brokers who had issues during these volatile times should focus on three areas:
- risk, and
There will undoubtedly be chaos as we approach the EU withdrawal deadline. Whilst the exact dates are unclear, all we can do for now is manage our risks on the information we have and ensure we are ready to react accordingly once the timeframes have been clarified.
Just like with the Yen flash crash, the market impact is likely to be across multiple asset classes and, even with a deadline extension, it is essential to ensure that risk and liquidity systems are configured properly.
Does your Liquidity Provider offer consistent execution during times of market stress? How transparent are they during these volatile times? Do they understand how pricing can affect the downstream retail traders? At the very least, does your Liquidity Provider even provide a price through extreme volatility?
Your Liquidity Provider should be able to understand and provide you with a setup that best fits your needs. Unfortunately, many Liquidity Providers simply don’t have the technical capabilities to provide bespoke solutions.
Some brokers prefer delivering a capped spread, especially if they are running a hybrid book model. Others aren’t worried about showing wider spreads during extreme volatility but they do not want to lose pricing, and some are even happy not showing a price, although this is rare.
A Liquidity Provider should be able to customise the setup based on the needs of the broker.
It is imperative to have a transparent relationship with your Liquidity Provider during times of market stress. You also want to make sure your Liquidity Provider has a strong relationship with their downstream Banks and LPs so that pricing and execution are optimised. When clients come to you asking about execution, as they undoubtedly will during market stress, you want to be sure you are armed with all the right answers.
Are you comfortable with your book? Are you certain your book is free of toxic activity? Is your book situated to capitalise on extreme volatility? Do you have a full understanding of negative balance risks you are carrying? Have you carefully measured counterparty risk?
Risk management isn’t just about classifying client flow. This is a large part of the everyday process, but there is so much more a risk manager should be doing. The number one cause of catastrophic broker losses in recent years boils down to either excess exposures or negative client balances. Risk teams need to focus on these areas and have clear policies within the group. Their policies need to be stress tested and brokers should know the negative balance risk at any given time – for example, are you aware of your potential losses if GBP moves 1/5/10%?
Another significant part of risk management is counterparty risk – unfortunately, risky counterparties seem to be on the rebound recently and we recommend you use caution. The old saying of “if it seems too good to be true….” is almost always accurate in our space.
Have you reviewed the performance and reliability of your operational systems to withstand above average stress?
Perhaps the most overlooked item to consider when dealing with large market events is also the most critical. It is crucial to trust servers and database hosting providers when the time is most vital. Without optimal technology, all other worst-case-scenario preparation is irrelevant. No matter what, all systems must be operating at peak efficiency during market events.
After reviewing all necessary points of risk and operations, and confirming your environment is appropriately aligned, large markets events such as Brexit should no longer be an item of stress and discomfort but instead can be an opportunity to capitalise on the volatility in the market.