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Published by: shekarm on Feb 18, 2012
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Date: October 15, 2007 Publication: Securities Industry News Subject: Risk Management in the Algorithmic Trading Equation (Page

1 of 3)

Risk Management in the Algo Trading Equation
By Brian Sentance The recent and continuing growth of algorithmic trading marks a fundamental change in the markets, one where the effects will be felt deeper as new markets and asset classes go electronic. With all the attention to algorithmic trading, risk management is moving down on financial institutions' agenda. Today, risk management is a once-a-day snapshot calculation of the level of market risk, even for electronic, sub-millisecond trading execution. Certainly the risk management profession has enough on its plate and more issues are on the way. The credit and operational risk requirements of Basel II are coming up for 2008, and compliance with Basel I on market risk continues to be challenging for many institutions. Then there are the recent subprime lending crisis and credit derivative exposures, the new modeling challenges of innovative structured products, and private equity and debt portfolios to model and manage. How is risk management responding to the rapid expansion in automated trading? Should risk management take on the challenge of moving toward intraday real-time measurement and management of risk? Calculating value at risk (VaR) for equities is relatively simple, since the asset class does not have non-linearities or multiple risk factors compared to more-complex derivative asset classes. For the simpler asset classes, the slow computations and data-intensive processes are not a problem to run as an end-of-day (EOD) batch process for later examination. Putting aside the modeling of private equity portfolios, equities are easy to model for most risk managers, requiring only relatively basic positional data and statistical analysis of historical market prices. As the securities world moves toward intraday automated equity trading, EOD risk measurement needs to keep up with the complexity and speed needed for advanced markets. This snapshot approach may leave financial institutions open to risk incurred intraday--risk that is not observable through EOD processes. While there is no positional risk exposure when undertaking algorithmic execution of orders on behalf of clients, risk managers need to assess how to deal with intraday positional risk arising from intraday proprietary trading models. Are the levels of net positional intraday exposure significant when compared to EOD levels? How is a trading desk to be appropriately charged internally for the capital it uses, if the measurement only takes place at some arbitrary time of day?

S. 2007 Publication: Securities Industry News Subject: Risk Management in the Algorithmic Trading Equation (Page 2 of 3) I am sure that for most institutions this is not a big issue--yet. The Data Deluge Moving on from the possibility of excessive intraday risk. However. Certainly some of the algorithmic trading vendors are seeing the value of intraday. At worst it could become a data management nightmare for risk management departments that are often far more involved in data cleansing and validation than they would like to be. Does the risk manager owe a duty of care to each separate trading desk. but also in the number of trading venues available (and therefore the number of sources of data that may need to be captured and stored). the institution as a whole. This development may require much greater cooperation among risk management. where risk managers would have knowledge of risks or exposures caused by trading conflicts between algorithmic trading desks (acting for clients) and proprietary trading desks (risking institutional capital). intra-period and real-time risk calculations. Even prior to the advent of computer-driven automated trading. or the regulator in this case? . Murphy's Law (whatever can go wrong will go wrong) is nowhere more at home than in financial markets. This would also raise issues around conflict of interest. In addition to having to establish what now represents a good market price (closing or otherwise) across many trading venues. To capture and store all the world's market data will take a database that is growing at around 3.5 terabytes per day. according to Tabb Group. once-a-day global risk calculation. we still need to "snap" market prices globally to ensure consistency of the data and risk numbers calculated.Date: October 15. trading and compliance departments. the markets have enough bad experiences of what can go wrong with intraday trading without adequate controls in place. automated trading. It is a simple concept. liquidity risk also needs to be accounted for. Europe and America do not happen at the same time and are not suitable (or even available) for a single. At best this looks like an opportunity for data aggregators such as Reuters and Bloomberg to sell more data. MiFID and NMS are also driving an increase not only in the number of trades. penny trading and regulations such as the Markets in Financial Instruments Directive (MiFID) in the European Union and Regulation National Market System (NMS) in the U. but closing prices for markets in Asia. have been the drivers behind the dramatic increase in transactional and market data that risk managers must deal with each day. Even if we stay with snapshot EOD risk management for the moment.

and risk management must become less conservative in adopting the high-performance technology that is making these advances in trading possible. Data and technology are the key drivers of progress. and how should this be approached? Can we leverage technologies such as clustering and grid computing and high-performance databases used in automated trading to do more intraday and be more responsive to market events? • • • • • • • In summary. pre-trade calculations as well as a posttrade snapshot VaR. . risk management and regulatory compliance purposes? Can we leverage this need for data and technology to bring trading. and are they real-time capable? Should risk management encompass both real-time. they need to look at a combination of factors. from a business risk point of view. I would suggest asking the following questions: • Is snapshot EOD risk management sufficient from a regulatory point of view. could this data be supplemented by maximum intraday exposure data? How can we best leverage the massive amounts of data now needed for trading.Date: October 15. perhaps risk management needs to apply more of its undeniable intellectual ability to keeping up with high-speed trading. risk management and compliance departments closer together organizationally? Are our data management systems supporting and adding value to risk management. and is time-consistency maintained for the global market data used? Are intraday exposures monitored? If still running EOD VaR calculations. 2007 Publication: Securities Industry News Subject: Risk Management in the Algorithmic Trading Equation (Page 3 of 3) How to Keep Up To begin weighing the factors of how institutions should reassess risk management efforts. or both? What is the justification for the choice of the EOD snapshot time.

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