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Super-fast traders pose risk to clearers
By Jeremy Grant

Published: November 30 2010 22:10 | Last updated: December 1 2010 09:29

Back in the 1960s in the City of London, when share trading was polite and clubby, it could take up to three weeks for share certificates and cash to change hands.

That was because traders trusted each other?s ability to pay up after cumbersome processes like credit checking were over. ?You would extend your counterparties two weeks of credit just because you probably went to school with them,? says Bruce Weber, professor of information management at the London Business School.

But now, in the world of ?high-frequency trading? (HFT), where much dealing is done faster than the blink of a human eye, everyone involved needs to know as quickly as possible whether traders can stand by their their bets.

Exchanges where the trades are done need, in particular, to know whether their customers have brakes in place to stop computer trading getting out of control. Sensitivity surrounding super-fast trading has heightened since May?s ?flash crash? in US stock markets, when the Dow Jones average plunged hundreds of points and rebounded in minutes.

US regulators are now piloting a system of circuit breakers at exchanges to help with this. Brokers who allow high-frequency traders to use their systems to access exchanges have been told to improve how they monitor the risks their customers take.

Industry experts say that high-frequency trading poses new risks for clearing houses, the central counterparties that stand between two parties to a trade and rely on funds contributed by members to pay out in the event of a default.

Clearers need to know whether those funds, which are known as margin, will cover the worst scenarios, such as a trader default or a trade going wild. They need to know this as far as possible in ?real time? since high-frequency traders put on and take off positions in microseconds in the course of a single day.

Nils-Robert Persson, executive chairman at Cinnober, a Swedish trading technology company, says high-frequency traders need to have ?a second opinion on their risk? since they pose new types of risks in markets. ?Much of the clearing house technology that you are seeing now is based on old systems and is out of date.?

Industry experts say intraday positions can be large. In the trading world many systems take snapshots of traders? positions every so often, say, every five minutes or longer. Yet five minutes in HFT can be a long time. ?You can have within that five minutes a massive spike and you wouldn?t know it,? says an executive at a technology company.

Efforts to tackle the risks for clearers have led this week to the launch of a service by Eurex Clearing, the clearing arm of Deutsche B?rse, which allows market participants to pre-set limits on the amount of risk they are prepared to take when trading. Thomas Book, member of the Eurex executive board responsible for clearing, says: ?A reactive risk management approach is not sufficient to cope with the increasing speed in the trading environment.?

In the US, CME Group, operator of the Chicago Mercantile Exchange and clearing houses, has already acted. It introduced a system last year that calculates margin requirements throughout the day. Amy McCormick, director of market risk management, says not all clearers are up to speed on updating their technology. ?Certainly I think all clearing houses are still working on this issue,? she says.

IntercontinentalExchange, a CME rival, sends customers reports on important financial information such as margin ?in near real time?. Paul Swann, chief executive of its London-based clearing house, says other clearers report this information only ?a couple of times a day.?

Xavier Rolet, chief executive of the London Stock Exchange points out an added problem. He says the fragmentation of trading across multiple venues ? exchanges, ?multilateral trading facilities? and ?dark pools? ? means national securities regulators often do not have access to a consolidated picture of trading and clearing activity.

?The next stage in the regulation and management of equities clearing risk is likely to involve intraday exposure management.

?Given that it is estimated that intraday HFT-type flow contributes in the region of 50 per cent of pan-European equity flows, real-time monitoring of intra-day flows and exposure in a fragmented environment is a logical and necessary next stage in market evolution,? Mr Rolet added.

Alexander Justham, director of markets at the UK?s Financial Services Authority, says that it is working to ensure international regulation and laws provide for ?the appropriate mitigation of intraday risk to central counterparties and their participants.? With such disparities in the information available, it is little wonder that regulators are only now starting to catch up
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