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Robert Schuessler
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A Smarter Monkey

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February 1, 2001

Trading on the Cheap

By James Marvin

Also in this article

  • Trading on the Cheap

Electronic trading is clearly having a profound impact on the financial community. As open outcry shifts to the trading screen, for example, traders are discovering the benefits of speed, efficiency and market access that sophisticated software can deliver. Trading firms are finding ways to add value to client relationships through shared technology. The Internet is indeed giving new meaning to the word "scalability."

What does this have to do with risk management? Everything. Technology has dramatically reduced the cost of trading. That means revenues from traditional services - such as execution fees, commissions, markups and floor brokerages - is less important while clearing is producing a greater part of a firm's profits. Execution fees, or floor brokerage, for example, on the CBOT is as high as $3.00 per round turn for some products, or $6.00 per trade. In the electronic world, brokerage is as low as $.50 per round turn and going lower. In some cases, firms are paying a premium to attract order flow just to get the clearing business.

In order to increase order flow and maximize clearing revenue, sellside firms are beginning to mass distribute trading screens to customers. That's a smart strategy. However, it also has the potential to cause major headaches for risk managers.

Managing risk internally can be a daunting task. When hundreds of clients are involved, it becomes downright frightening.

In order to manage risk effectively with this mass distribution business model, sophisticated risk management tools must be an integral component of any electronic trading system. Trading firms must be able to establish trading limits on a client-by-client basis, yet be capable of monitoring risk without having to constantly track each individual account. Software systems are becoming more sophisticated to accommodate the new demands. At Trading Technologies, for instance, we provide pre-execution credit management through our X_RISKTM software. X_RISKTM, offered through both our PC- and Internet-based trading platforms, ensures that trades clear pre-defined risk parameters before they are executed. The system ensures that any trade that falls outside of the set parameters will not be sent to the market.

Firms may also decide to manage risk on a post-trade basis for clients with higher volume traders, or those with a more established trading record. Post-trade risk management involves setting thresholds for traders based on a certain dollar amount or trading volume. When these thresholds are reached, triggers are automatically sent to the risk manager.

As with any automated system, human intervention should be possible. X_RISKTM provides a manual override feature, through which trades that exceed set parameters may be authorized by the firm on a case-by-case basis. An established trader may decide to trade an additional 100 contracts of a certain product on a given day. While the system will alert the risk manager that the trader has exceeded his/her volume limit, the manager may decide to authorize the trade based on the individual customer's record or history with the firm. The idea is that technology will be leveraged to manage the bulk of risk management and prioritize those exceptions, which may need human intervention. This is the key to scalability.