Deutsche Bank: What to do when you algo fails a risk check

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Traders yearn to execute trades faster than the competition and now, thanks to fast networks, they can cut complex deals in the blink of an eye. Cut to the risk manager reaching for his or her Tylenol. What does a smart risk officer and CIO do to make sure that the next super-fast trade doesn't bring down the whole house?  

It's a vexing problem. Traders are racing to reach alpha and the people who run the technology need to make sure that the risk mitigation systems can weigh in on the trade before it incurs any damage. This requires real-time data, fast and assured diagnostics, and a kill switch to stop a trade that looks either a bit off-kilter or completely unhinged.

Greg Wood, Deutsche Bank's director of algorithmic execution for listed derivatives and foreign exchange, and FPL director, recently discussed kill switches and other hot button issues that were included in the FPL's recent industry guide on risk management.

Here are a few excerpts from the interview, which ran in Wall Street & Technology.

Q: What were the most hotly discussed issues of the new risk guidelines?

Greg Wood: One thing that provoked much discussion was the concept of "pausing" an order when it fails a risk check on arrival at the broker. It is important to note that brokers would never pause an order sent directly to market if it fails a risk check – those orders need to be rejected immediately. However in certain situations orders that are routed to a broker's execution algorithm can have more time before they start trading, particularly if they are equity orders sent before the open. This allows the broker to pause the order while they understand the reason behind the risk check failure. Once that is understood, the broker accepts or rejects the order accordingly.

Q: What are some of the other highlights of the new guidelines?

Wood: We introduced an additional FIX message that allows us to communicate when an order has been paused. It's an evolution of what brokers have been doing for several years. Most equities brokers have someone on the desk that picks up the phone to the client and reviews an order that fails a risk check. Current practice when an order is paused at the broker means that the client doesn't know if it's been accepted or rejected without that phone call. We've added an extra tag/value within the "Pending New" message to denote that the order has failed an algo risk check. This is sent back to the client's system and the order's state will be changed to "paused", as opposed to leaving it in limbo. This electronically alerts the client of what has occurred.

Q: What happens when a client receives an alert?

Wood: Either they contact the broker or more likely the broker will contact them. As noted before, brokers will only use a pause message in particular situations: i.e. if the order exceeds a certain limit when we know the timeframe for execution is not critical. If an order was due to execute immediately it would be cleanly rejected.

For more:
-read the entire Q&A

 

 

Jess