INSIDE VIEW: A lesson from abroad

TimerIn some quarters, high frequency traders have been blamed for the mini-crashes in the United States, but Alice Botis, of Fidessa, asks if Brazil can manage pre-trade risk as it opens its doors to this community. Thanks to some very competitive exchange prices for day trading, the high frequency trading community has started to set up shop in Brazil. Current estimates suggest that 5% of trades on the Brazilian Securities, Commodities and Futures Exchange, the BM&FBOVESPA, can be attributed to high frequency traders and, with a policy in place to attract more, that number is set to increase. The jury is still out about the benefits that high frequency trading brings to any market. Its proponents will argue that high frequency traders provide what amounts to a market-making activity that creates valuable liquidity and has been credited with reducing bid/ask  spreads and making markets more efficient for everyone. On the other hand, high frequency trading firms are not obliged to always make liquidity available and so have been criticised for pulling out of markets when conditions are volatile. The nay-sayers point to the dramatic fluctuations in price in the United States, and lay the mini-crashes firmly at the feet of high frequency traders. But it is not clear whether this is a case of causation or correlation. The more likely culprit is not high frequency trading per se, but naked access (which is now in the process of being banned in the US) and the more general failure in some quarters to manage pre-trade  risk. It is here that Brazil, as a later adopter and long-time observer of the high frequency trading phenomenon elsewhere, has a distinct advantage. Risk checks
From the outset, the Comissão de Valores Mobiliários (CVM) has put robust pre-trade risk checking requirements in place, and has never allowed naked access. It has encouraged the exchange to put circuit breakers in place to limit the contagion of risky trading activities. And it has specified a number of risk checks that must be performed pre-trade, and applied different parameters according to the liquidity of the stocks concerned. The more pertinent question in Brazil, therefore, is not what checks should be carried out, but where and by whom. The country has four distinct direct market access (DMA) categories. In the first category (DMA 1), buy-side clients use their broker’s existing connectivity to  the exchange. In  the second (DMA 2), which is more of a distribution model, buy-side firms use an authorised provider to access the exchange, which allows them to maintain a roster of competitive brokers. However, both of these models place the burden of  responsibility for checking, configuring and controlling their clients’ limits with the broker. In both cases, the checks performed by the broker must mimic those conducted at the exchange. In contrast, the third and  fourth categories, where buyside firms connect directly using their own infrastructure (DMA 3), or work on a fully colocated basis (DMA 4), the exchange provides the pretrade risk control tool themselves. These are the areas that have traditionally  been of concern, as the client order goes direct to the exchange without the broker intervening. High frequency trading falls in the DMA 4 category. Increasingly, firms are opting for proximity hosting over co-location, which is closer to a DMA 1 or DMA 2 scenario because it  uses a broker data centre. Consequently, the responsibility for pre-trade risk checks shifts back to the broker. The question here is which method is preferable in this rapidly changing environment. The exchange will argue that by performing risk checks itself, it creates a fair playing field since all players are working with the same level of latency.On theother hand, brokers point out that this is a valid source of competitive advantage and they need to have more control over their clients’ risk parameters. The debate is ongoing, but what seems clearer is that there is also a degree of future proofing to be gained from broker-level risk checking. Certainly, it enables brokers to apply broader risk checks on top of those mandated by the CVM, and to take control of their own risk parameters both at a client and individual order level.What is more, it enables brokers to co-mingle equity and derivative risk checks at a firm level, which is a significant advantage. Most importantly, brokers can conduct risk checks over multiple venues, which is an essential feature in a fragmented market.With BATS openly discussing a potential launch in Bazil, and severalother consortiums in play, this will be the critical issue, not just for the high frequency trading community but for all other players in the Brazilian market. The potential for changing the risk equation in this marketplace is enormous and the debate around the best solution will continue to rage on. Alice Botis is head of Latin American business development at Fidessa ©2012 funds global 

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