PRE-TRADE RISK MANAGEMENT
On the exchange side, the move to CCP clearing
also means that non-members will be required to manage pre-trade risk more effectively. Given that there are a large number of trading firms (exponentially more than the downstream players – clearers and exchanges), the effects on the markets could be detrimental. Maximising a trading firm’s capital – by using pre-trade processes – represents one of the biggest gains for trading firms. And in order to achieve this, the pre-trade process should map real profiles, closely matching the post-trade element, thus reducing the ‘buffer’ between the two.
Pre-Trade Risks Pre-trade risk controls are the first step in the
assessment of the trading cycle. The key elements are risk, liquidity, technology and regulation. The challenge at this level of the supply chain is enforcement. This primarily involves the establishment of
limits; limits on the maximum potential long (and short) positions in which a firm can transact (be they quantity and/or nominal value based) and the order sizes available. This translates into a maximum loss (and minimum cash balance) the firm can allow. The essential risk management controls for
brokers, dealers and others who provide market access include:
• Financial risk management control and supervision: designed to prevent the entry of
orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous.
• Regulatory risk management control and supervision: designed to prevent the entry
of orders unless there has been compliance with all regulatory requirements that must be satisfied on a pre-order entry basis; prevent the entry of orders that the broker or dealer or customer is restricted from trading; restrict market access technology and systems to authorized persons; and assure appropriate surveillance personnel receive immediate post- trade execution reports.
Power and gas markets traditionally only had
post-trade risk systems in place. Henceforward, trading firms in the energy sector will be required to establish a range of order parameters in putting controls on trading activity at the order level. This pre-trade risk management architecture must be designed to help optimise a firm’s ability to manage and make full use of available trading limits in order to maximise the use of capital committed to the trading process.
Therefore, in order to foster a more vibrant
trading market, both post AND pre-trade solutions are now required to be put in place for market participants in order to conform with evolving regulatory policy and market practice in the face of capital constraints – particularly on behalf of banks and Prime Brokers. A key concern in pre-trade risk management
for trading participants is assuring the quality of systems (and deciding how far to go with the more complex controls) in order to optimise the use of available capital and margin. For the energy sector, the risk profiles of transactions are extremely complex, and possibly one of the reasons why widespread pre-trade risk management has not really existed – until now. The challenge then becomes one of mapping this discipline across to the ways in which power and gas etc. are traded, with the ability to reduce margin calls on trading activity – with an accuracy of pre-trade that maps the real profiles of transactions – just as in post-trade.
... the goal is for trading firms to demonstrate
... that pre-trade risk assessments and systems capabilities are in place
Risk management in commodities trading has
historically focused on post-trade risk. There has been a clear lack of pre-trade risk controls in energy trading markets and General Clearing Members (GCMs) have started to get worried about their risk exposure. Accordingly, GCMs have been reluctant to sign up new clients and provide them with direct market access without pre-trade risk controls (across asset classes). Trayport, a leading provider of energy trading solutions to traders, brokers and exchanges, has undertaken extensive market research and consultation into the pre-trade risk environment – the why and the how? Chief among concerns for the market are: 1 New regulations and how they affect the energy trading industry – volumes, liquidity, etc., and
2 How regulatory driven controls are impacting the capital status of participant firms.
Energy Market Access Gateway To help solve companies’ pre-trade risk management undertakings, Trayport has launched the Energy Market Access GatewaySM
– ‘EMAG’ – a
pre-trade risk and market access system. EMAG controls credit exposure and ensures that
only pre-checked orders are sent to an electronic OTC venue or exchange. The system has been
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