The pandemic-driven events of the last 12 months have demonstrated just how complex and critical risk management has become in the FX market. They have also highlighted the importance of implementing modern risk management programmes that employ automated workflow, rules-based risk engines and multiple technology stacks.
It may still be the same risks facing FX brokers – toxic flow, liquidity mismatches and risky trading behaviour – but Covid 19 has amplified these risks as volatility and trading volumes have both increased. For FX brokers, it has put their risk management strategy and infrastructure under the spotlight.
The Achilles heel that many FX brokers struggle with is the absence of an all-in-one risk management framework that monitors the entire company’s trading operations and produces data-driven analytical results and actions, on a fully automated real-time basis, says Cristian Vlasceanu, chief executive of Centroid Solutions, a trading technology firm. “For example, many medium size FX brokers run their business using multiple trading platforms and services developed by different vendors. Very often those technologies either completely lack or include only a subset of risk management functionalities specific only to that trading technology and isolated from the other trading platforms. In addition, those systems do not have an out-of-the-box functionality to exchange data freely amongst one another.”
As a result, says Vlasceanu, a lot of trading data is fragmented across different systems, causing brokers to perform substantial amount of time-consuming manual work, just to aggregate a complete picture about the risks involved. “This shortcoming results in a time-lag for critical risk related decisions based on current exposure dynamics. However, the ability to measure risks in real-time at the level of asset class, currency, USD notional, concentrations, and flow toxicity, is vital for identifying and mitigating risks in a timely manner, especially during times of high market volatility.”
Covid-19 has brought an increased volatility into the markets, leading to higher volumes and increased client engagements. However, volatility is also a proxy for risk - the higher the volatility, the higher the risks, says Vlasceanu. “Therefore, during such times, it is especially important for FX brokers to have proper fully automated real-time risk management solutions to cope with market movements and associated risks.”
Most FX brokers lack the expertise to build their in-house risk management technology, especially given the growing complexity of logic involved and the vast amounts of data that needs to be processed, simulated and analysed in real-time, so it makes sense to turn to third party market. Fortunately, says Vlasceanu, as firms have moved away from their own in-house technology to mainstream trading platforms, integration with external risk management systems has become easier and more cost efficient due to the reduced cost of computing power and connectivity.
One of the main benefits of a proper risk management system is that it helps to establish clear visibility of revenue drivers and proper classification of customer flow, says Andrei Savitski, Centroid Solutions’ Global Business Development Manager. “One common misconception of many small to medium size FX brokers who run hybrid business models, is that their revenue is coming primarily from taking the other side of the trade and benefiting on the b-book from client losses. However, in practice, on average, over 70% of a hybrid FX broker warehousing revenue is coming from the spread and commissions, and this data is supported by the published financial performance reports of large publicly listed FX brokers.”
“In other words, established FX brokers, operating for years, have been focusing on providing consistent quality execution to their clients in order to grow a loyal customer base and trading volumes, and thus capitalise on the main revenue driver: spread revenue, regardless of the market dynamics. Thus, established brokers focus on filling the client first, followed by an advanced internalisation process,” says Savitski.
The key to a successful hybrid business model is to have an execution technology that is able to single-out toxic trades in an intelligent manner, based on real-time risk analytical results, says Savitski. “Another misconception by many FX brokers is to perceive profitable client flow as toxic flow. However, this is not necessarily the case. Professional risk management systems are able to distinguish and detect the true toxic flow and effectively mitigate it,” he adds.
“For instance, nowadays, we see more and more automated trading strategies from clients which track latency and benefit from discounted prices to go in-and-out of the trade within milliseconds, not allowing a hybrid discounted broker to hedge the exposure or crossmatch it with counterparties. That is why, in addition to proper analytical tools, it is highly important to have an execution capability that would detect and STP toxic trades, in real-time, at the point of execution. The need for advanced execution solutions, driven by real-time risk management and data analytics, is apparent in this situation,” says Savitski.
It has also become essential to use a rules-based risk management system in order to classify, allocate and optimise clients’ flow in difficult market conditions, says Savitski. “FX brokers must deal with a multitude of quantitative risk factors simultaneously, at many different levels: portfolio, asset class, instrument, currency, client and trade. The main benefit of a rule-based risk management system is that it offers precise control for identifying and handling risks at the level of individual trades. It allows to track any combinations of risk factors in real-time, and allocate clients’ trades, on-the-fly, at the point of execution. It also offers maximum flexibility for adjusting risk parameters and optimizing trade flows under different market conditions. We believe that risk cannot be looked at in isolation of the balance sheet of the broker, therefore, brokers should set risk limits in relation to volatility, balance sheet, and the nature of their flow from an exposure holding period perspective. A rule-based risk management system offers the flexibility to define such risk strategies, in advance, to control and manage any market environments,” says Savitski.
What to look for from a provider
So what should an FX broker look for in a risk management provider? “It is important to look at a provider that specializes in this field and comes from a practical background because risk management technology must produce relevant analytical insights which address real practical needs of the broker’s dealing desk,” says Vlasceanu.
“Proper risk management technology cannot work in isolation and must be an all-in-one solution, covering all areas of risk management with centralised visibility over the entire operations and all data. Additionally, the risk management technology must provide maximum level of automation, producing analytical results in real-time, to eliminate manual data crunching and empower the dealing room and executives with proper business intelligence and up-to-date decision-making information.
“Moreover, each broker has its own view about risk, so a risk management technology should be flexible to accommodate bespoke customisations easily, to meet unique requirements and preferences of each FX broker. Finally, risk management must not be disconnected from the trade execution process. It is becoming increasingly important to have an execution technology that is able to work based on the real-time risk analytical results, in order to address risks automatically, at the point of execution,” says Vlasceanu.
Pros and cons
While the use of automation has increased, manual risk management still exist and balancing the two is one of the biggest risk management issues facing FX brokers, says Lea Wang, executive vice president of a Cyprus-based trading technology provider PLUGIT. “Each way has its pros and cons. With manual management, the risk team can identify various risky trading behaviours, but it may not be as efficient because it is totally based on the experience of the risk manager. Risk management tools are usually based on pre-defined rules, so they are highly efficient but cannot react as quickly when it comes to unrecognised or undefined risky behaviour,” says Wang.
But getting the best of both worlds is not as straight-forward as it should be, says Wang. “We often hear from brokers there aren’t enough tools in the market that can help them manage risk in a cost-efficient way. Good tools are usually expensive, whereas more affordable tools may have very limited features and functions.”
When it comes to identifying the right technology partner, Wang highlights the importance of the technology infrastructure. “This is often overlooked by brokers but the underlying infrastructure of any given software determines its sustainability and future development, which also directly impacts the users. Two systems may have similar functionality but if one is built on an outdated technology it may have quite a few limitations – an inconvenient user interface, difficulty to upgrade and debug, a longer overall time to fix when there are issues.”
One of the biggest risk management issues we see brokers face is the exposure to risk during times of unexpected volatility, says Jalal Faour, chief executive, and founder of PLUGIT. “In addition, liquidity providers are often increasing margins when they anticipate volatility, which means brokers need more margin to cover exposure during these times.”
The use of risk-related data and analytics can not only manage liquidity issues but also have a dramatic impact on the bottom line when used in the dealing room, says Faour. “The ability to identify high risk clients in advance and take both manual and automated measures of protection is of significant value to any dealing desk. The key is providing a visualisation of the risks on the book and also providing automated tools to mitigate risks such as dynamically adjusting margins based on client exposure.”
Automation is critical to optimising risk management technology for the retail FX brokerages experiencing high volumes of clients and activity beyond what can be catered for by manual processes as well helping brokers to hedge positions, says Faour. “Automated dealing tools and bridges can provide huge benefits to market makers looking to hedge their exposure without human intervention. They can also handle complex hedging models that it would be impossible for a human dealer to mimic. Again, this all impacts the bottom line so the smarter the broker and the more technology they use in this area the more profitable they should be.”
Experience and a deeper understanding of brokerage and market-making models are essential when looking for technology partners, says Faour. “Solutions developed around experience typically excel. The quality of the tools and how they work should also be assessed and properly understood. It may sound cliché but relationships count and finding a provider that is there to support you at all times has true value.”
Due to the volatility created by Covid 19, the biggest risk facing FX brokers currently is matching liquidity with taker behaviour, says Brian Ellison, product designer at trading technology firm oneZero. “Brokers need to price clients appropriately, by making sure they are facing the right liquidity in liquidity pools, and classifying each of the takers according to the appropriate risk bucket. Covid 19 has brought about increased volatility, changing the profile of the takers. With that comes the reclassifying of takers into appropriate categories, and with the various market swings, it has become harder to match the takers to the liquidity to ensure that you are hedging that appropriately.”
In order to manage your liquidity and risk management brokers need to ensure they have reliable, curated, clean data on their customer flow, says Ellison. “We have spent a lot of time making sure curated data is available to clients,” he says. “This includes interactive, visual web-based analytics that enable brokers to answer key questions that help them understand the characteristics of their client flow and associated hedges, and the relationships they hold with their liquidity providers.”
Building automation into risk management workflow is also one of the key elements for successful retail FX brokers, says Ellison. “With automation and systematic hedging, you can do a lot more with less. Machines are much more efficient than humans at managing risk, as they are able to look at more data sets faster. You are leveraging compute technology versus human brain reaction time. If you aren’t automating, you are probably missing opportunities because you are too slow to respond. You may be increasing your risk tolerance and threshold without knowing it.”
Technology also helps brokers to hedge positions, by reacting to the inputs that you have provided, says Ellison. “oneZero has built a risk management system that can take in all kinds of inputs, whether positional, time, profitability or taker, and the technology hedges the positions accordingly. Our technology takes in all the inputs, monitors the market and all the thousands of variables that are happening throughout the day, and creates the output you are requesting.”
There is definitely greater use of rules-based risk management systems, says Ellison. “The inputs can be based on volatility surrounding market events or even trading sessions. You want to be able to switch your risk management and hedging profiles according to what is happening, for example if there is an economic number release, or you might like to price differently depending on the market, for example Asia or US. With rules-based risk management systems, you can have cross-workflows and switch between market environments and trading sessions.”
Ultimately, says Ellison, brokers need flexibility for their inputs and reliability for their outputs. “You need a system that allows brokers to make thousands of maker rules, while being very consistent in the output. Of course, the technology also needs to be stable enough to handle all the different inputs without crashing.”
Blessing and a curse
2020 was both a blessing and a curse for many FX brokers, says Albina Zhdanova, chief operating officer of Tools for Brokers. “The pandemic created a demand for people to have alternative sources of income, which caused a spike of new traders joining the market. Many brokers experienced rapid growth and had to quickly adapt new strategies and products to maintain and improve their service levels. Another big risk continues to be high market volatility. When the market goes up and down, there is a temptation to risk more. But where there is big profit, there is a big loss. So what we saw was many brokers looking for ways to protect their traders and themselves from any extra risks by implementing various tools, such as that control accounts’ leverage, margin levels, and other high-risk parameters.”
As the market has evolved, the importance of risk management has become more evident, as has its promotion, says Zhdanova. “Whether it is through blog posts or rolling out products on the markets, there is definitely more conversation about it than it was maybe a few years ago. As a result, more brokers educate themselves, realise the importance of risk management, and look for solutions for their companies.”
Brokers have also realised that the data from risk management systems can be viewed as business intelligence that can enhance their performance in multiple ways, from getting timely alerts about strange behaviours and acting accordingly, to reviewing the history of trading, analysing the trends, and updating the strategy, says Zhdanova. “There are countless insights that data analytics provides which help optimize the processes. A lot of the potential issues or threats can be avoided if brokers choose to monitor and run reports on their data regularly.”
The right technology will also help brokers to hedge their positions by providing the data statistics to analyse historical trends and make forecasts, says Zhdanova. “It will also help process large quantities of data quickly, make quick decisions, get notifications on any abnormalities to correct their action plan.”
In addition to regular data reviews, automation is the other critical component to risk management,” says Zhdanova. “I cannot stress enough how critical automation is for brokers. Brokers deal with enormous amounts of data, and any delay or mistake can result in reputation damage, loss of clients, and sometimes even lawsuits. Automation helps avoid delays, human errors and free up the time for analytics, business process optimisation, and conversations with prospects. So, automation is one of the factors that help companies grow.”
Zhdanova says there are two key properties that brokers should look for in their technology partners. “First of all, the best partner would provide an ecosystem of products to the brokers. It can work to have multiple vendors installed together in a single environment. However, should something happen, such as a server going down, it is much easier to troubleshoot and fix the issues if there is only one vendor involved. The same goes for updates and patches - once one of the tech products releases an update, there is a risk that this new edition will cause errors with the rest of the infrastructure.”
Secondly, says Zhdanova, a broker should understand their technology partner’s core beliefs and strategy. “It may not sound too critical but it will determine the future direction of the partner, what products they release next, and what they consider important.”