The Three Most Often Overlooked Pitfalls In Risk Management
The topic of risk management has been making headlines ever since the SNB crisis proved that no one in the Forex industry can feel safe. Many called it “a lesson taught to everyone.” But even after all the media buzz, technology improvements, and leverage decrease, are brokers seeing the full picture? What if there was something important missing from the very start?
There is no risk policy in a brokerage
Who is always on the front checking the risk exposure or trade reconciliation? In most of FX brokerages, this job is done by dealers. What background does an average dealer come from? Finance? Management? Math? Nope — all wrong. In fact, some dealers have almost no experience when it comes to understanding the nature of market risk and volatile environments.
The only solution to keep them in check is an internal regulation document called Risk Policy. Written by a single person from the company who has vast experience with risk management and approved by the board of directors, it will serve as the backbone of everyday operations.
The dealer found a position mismatch? Look for the corresponding clause in Risk Policy. Want to make something not specified in the Risk Policy? Make a suggestion to Risk Policy.
Over the course of time, the document will be filled with more details and cases, so it will cover the vast majority of a dealer’s routine and ensure the stability of the business, even if a key employee decides to leave the company.
Your STP flow can be as vulnerable as B-book one
Until the 15th of January, 2015 brokers have been working under the assumption that “full STP” is much safer than B-booking or any hybrid model. One way or another, if a broker decided to pass all trading risk to your liquidity providers, he is protected from the toxic strategies of clients or volatility, right?
Well, that’s never been true. If you look at the aftermath of the Black Swan, you can see that it was A-book brokerages who suffered most of the losses — FXCM, Saxo, Boston Prime, Alpari UK, just to name a few. Moreover, institutional clients (small and medium brokers) who kept accounts in such companies also took losses, yet we will never know their names.
While the capital requirements for opening a STP brokerage are significantly lower than for opening a B-book one, the broker should take extreme precautions to protect his money from possible events like position mismatch, stopout on your LP’s account, errors with execution reports, cancellation of already executed trades, and so on. Another issue to watch for is segregation of funds. If your liquidity provider uses your funds as collateral for its own trades, then your trades are as vulnerable as your LP’s trades. Furthermore, any insolvency of the liquidity provider will put your business in danger as well.
Keep an eye on your clients, not on the news
Let’s imagine a risk manager on Friday preparing for a busy week ahead. What is he looking for? Economic calendar, news, announcements, forecasts, etc. And what will he find? Experts’ opinions of all sorts: “We’re decreasing leverage to 1:25 on all pairs,” “some currency pairs switched to ‘close only,’” “watch out for that massive spike on EURGBP” — all the regular fluff.
While I’m not judging whether what they say is true or false, one thing is clear: they are giving advice based on THEIR clients, not YOUR clients.
It may look like traders are the same everywhere, but in fact, when technology and liquidity in retail FX can be roughly equal, the real difference between brokers comes down to sales approach and their clientele. When it comes to what decision a risk manager should make, it must be based on his clients, not others’ clients.
He should develop a routine to gather and evaluate all trading flow stats: how did traders respond to a non-farm payroll or central bank announcement? Which trading hours are the most active and how do they correlate with the news? What’s the distribution of the clients’ trading patterns? The more data he has behind, and the more he extracts from it, the better he will be prepared for the future.
Black Swans are important, but not for everyone
Once something huge like SNBomb hits, it attracts the attention of the whole industry. Its damage is massive, but in my opinion, the reception of the whole event was overblown. Yes, some companies took huge losses, some dissolved, but the majority of the market participants got away unscathed.
If you look at the whole history of retail FX, it is clear that most companies went down not because of Black Swans, but because of running their books poorly. I hope that this article will help you avoid their mistakes.