Liquidation Only. Did your heart skip a beat? In futures and options trading when we hear “Liquidation Only” it means that something went wrong. Someone is losing money. The broker wants all new investments to stop.

In the world of electronic trading with direct access through software there is no longer someone thinking about the client and the broker’s role prior to orders being executed. We expect the computer to protect us.

 But it can’t. Not yet.

 Software pre-trade risk checks and back-office margin or risk controls all provide great tools to help prevent a trader from over extending their ability to invest with further trades. Yet they sometimes seem to be weak when you consider that these systems are designed for speed.  Let’s take a look at the controls that exists.

eTrading Software Pre-Trade Risk

• Fat Finger or Order Size Risk: Prevents a single large order from entering the market. Prevents someone from entering “Sell 100 at $1.00” when they meant “Sell 1 at $100.00”.

• Position Limits: Prevents a large accumulation in any one financial instrument.

• Message Throttle: Prevents a large quantity of orders going in too quickly. This prevents errors like someone leaning on a keyboard or a rogue algo.

• Price Collars: Prevents errors related to an order being entered for a price too far away from the market to be reasonable.

 These examples of controls are all good. Yet they typically have one fundamental flaw in their design; they require complete knowledge of all orders and positions. This is something that they very rarely if ever have.

 A prudent trader will have two trading systems, a primary and a backup. In the case that he or she is unable to enter an order in one system they can use another. The trader also has the capability to call a desk broker. In either case, no single system will have a complete view of all orders on any given day.

 The complete view can also be compromised by linkage to the back office systems. Not all eTrading systems take a start of day feed from the back office and therefore do not know the true position. They may be very accurate on activity for the day. But consider the following:

• Day 1. Trader accumulates 100 Jelly Bean Futures by calling the trading desk and placing an order. Position = Long 100.

• Day 2. Trader places an order to sell 100 using a stop loss order to prevent losing too much money if the price of jelly beans falls.

 On day 2, the eTrading software may only know about the sell order. If it gets filled it may consider the position to be short 100 instead of zero.

Back-Office Margin or Risk Controls

Clearing firms calculate the margin requirements for each account every night. Many are now keeping an intraday calculation that is near real time. This ensures that the account has enough funds on deposit to cover the position.  

 The back-office system feeds have the advantage of seeing all trades regardless of the source of the trade. Therefore the trader using two or more trading systems has positions consolidated in the back-office system. This is especially true if the trader is using multiple brokers.

 The risk department at the clearing firms also calculate various risk profiles using post trade positions. These risk profiles may include industry standard calculations like:

• SPAN - the industry Standardized Portfolio Analysis of Risk which takes consideration between related contracts and options that may be hedging a position.

• VaR - An industry standard calculation that is used to evaluate the investment portfolio over time.

 Each risk department evaluates their portfolio according to the unique needs of the brokerage firm and the client profile.

 If a risk department determines that the account has exceeded the approved margin they may place the account into liquidation only. This will prevent any new positions from being added to the account.

 The functional shortfall that exists here is that the back-office or risk department rarely know about hedging orders that are entered in the electronic trading systems. For example:

• An account has 100 Jelly Bean Futures Contracts.

• The account has an open order to Sell those contracts if the price falls by 10% that remains open until cancelled.

In this case the account isn’t hedged according to SPAN or Var but it is hedged in terms of the open order. This account is not as risky as the account that only has an open position.

 Secondly, because the trading systems rarely have a full view of all positions it is difficult to tell a trading system to implement Liquidation Only.

The Kill Switch

In recent years the idea of a kill switch has been implemented. The concept is that the risk department or the trader’s manager can press a button to prevent any additional trading from happening. To do this the kill switch instructs the trading system or market to cancel all open orders. This idea sounds very appealing especially in an algorithmic trading and high frequency trading world.

 Having the ability to stop trading is important. Yet the questions that come to mind include:

• Who or what makes the decision to stop trading?

• How do you stop trading?

• What about open orders in the market? Which should be cancelled and which shouldn’t be cancelled?

• What orders should be allowed to close out of a position?

• Since most traders have more than one access point to trade, what are the access points that need to be killed?

• Will killing the access point achieve the desired result?

• Will pressing the kill switch increase or decrease the brokerage firm liabilities?

 The state of the market for kill switches have never made many comfortable with the idea that anyone will press a kill switch because no one has been able to answer these questions.

 Don’t be discouraged. Exchange kill switches, and external kill switches (for example Kill Switch+) are advancing the capabilities by adding more sophisticated controls that catch runaway algos, measure risk in terms of financial loss instead of contract counts, and are merging trading from multiple sources including drop copies. Yet the technology isn’t fully where it needs to go yet. There remains more work to be done.

The Future of Pre-Trade and At-Trade Risk Controls

In the future we will see the front office pre-trade risk technology, the back office systems, and the risk modelling systems working more collaboratively. This will require:

• More risk departments being able to push approved pre-trade risk limits out to the front office trading systems.

• Pre-Trade risk controls will move from commonly used contract counts to financial measurements (e.g. profit/loss, real time margin requirements, etc.)

• Alarms being generated to Risk Managers when an approved pre-trade risk limit is increased without approval.

• Credit approvals being reconciled with pre-trade and post-trade risk configurations. Credit committees, risk departments, and pre-trade support staffs have a separation of duties but should be better linked.

• Back office Systems being able to transmit new trades to eTrading systems throughout the day as they appear in back office.

• eTrading systems reconciling between the trades done in the eTrading system and those that appeared in the back office so that there is an accurate current position for the eTrading system to use for pre-trade risk.

• Risk Management systems being able to see the true risk of both the positions and the open order book for an account.

• Trade allocations (middle office moving of positions from one account to another) happening intraday so that all risk systems are aware of the position changes.

• Kill switches that can implement a Liquidation Only instruction.

• Electronic trading systems that can implement a Liquidation Only instruction.

While some systems have partially implemented these future controls there is still a lot of work yet to be completed.

Recommended Reading

The Futures Industry Association (FIA) Principal Traders Group “Recommendations for Risk Controls for Trading Firms” from November 4th, 2010.