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Thoughts on Central Risk Books & Market Access Rules
Traders Magazine Online News, August 8, 2017
Central Risk Books (CRBs) Are Coming of Age
An article in Financial News goes into some depth examining CRBs, which is a favorite topic of mine since I built the first version of a CRB at Salomon Smith Barney over 15 years ago. This article, which delves deeply into the trader view of CRBs, makes a few important points:
- CRBs are becoming a necessity for trading firms to compete
- CRBs are viewed by traders with suspicion & “gaming” is a serious concern
- CRBs can potentially obfuscate proprietary trading by providing a justification for hedging for trades.
On the first point, all I can say is: it’s about time! When we built the 1.0 version of the CRB at Salomon Smith Barney, we were limited by the internal politics between my quantitative team and the cash traders, to handling the positions that resulted from retail orders only. As this article reports, however, the concept has gained traction over the past 15 years, which is welcome news for the industry, as liquidity is at a premium. While it is not a trivial undertaking, a CRB that handles the full portfolio of risk taken by all the individual trading desks is the optimal method for minimizing trading costs, managing risk, and, therefore, providing liquidity.
The second point, suspicion and gaming, has always been the most difficult to overcome. Proper architecture of a CRB includes a couple of important design points. First, traders must have well-defined rules for “keeping” positions and such activities must include proper attribution and analysis. A CRB which did not allow traders to express opinions on future price direction would sacrifice a major source of profits. Such decisions, however, must be attributed to the decision-maker and analyzed to ensure that those traders add value over time. In addition, the method of transferring risk to the CRB must be clearly defined and not subject to manipulation. Systems that transfer positions without regard to estimated transaction costs, for example, are problematic as they are open to being gamed. To explain this, consider a trader that facilitates a client and buys a large position. Without a transfer mechanism that is sensitive to the size of positions, however, the trader would be incentivized to expand the position in the market before the transfer, as that will push the price higher. The result would be unrealized profit for the trader, while the CRB would inherit a more expensive position to liquidate.
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