The trading life cycle

Ali Curi: Markets ConversatION is a new ION podcast where we discuss topics of importance to capital markets participants with product owners, subject matter experts, and industry leaders.

Alex Lamb: When you come into, um, the financial markets, businesses, you need to understand what the opportunities are. Pick up as much information as you can.

And be as flexible as you can be in order to discover those opportunities and then exploit them both for yourself and the people that you’re working with.

Ali Curi: Hi everyone, and welcome to Markets ConversatION. I’m Ali Curi. On today’s episode, we’ll discuss how technology has not only transformed the trading life cycle, but has also presented challenges for risk managers.

Technology and automation have been the great leap forward for many industries, especially finance. And with us to discuss the trading life cycle and how different types of margins affect the profitability of trades is our guest, Alex Lamb. Alex has been in finance for many years and he’s worked in all facets of the trading industry, helping create and improve software companies and products, but what’s been keeping him busy lately is tackling risk management and surveillance. Let’s get started.

Alex Lamb, welcome to the podcast. Thank you for joining me.

Alex Lamb: Thank you very much for inviting me. I’m pleased to be here.

Ali Curi: Alex, before we get to our conversation, let’s learn more about you. Tell us about your career and what led you to where you are today.

Alex Lamb: Thank you for asking. I started off in the back office of a commodity brokerage company and had the opportunity to literally branch out into every asset class, uh, as either a broker, or a trader, or a manager. And throughout that career I’ve been involved in risk management, either managing, uh, clearing systems, managing accounts for clients, and managing a bank in Germany. And then towards the end of the nineties, I stepped from being on the business side where I touched technology on a regular basis to being in the technology side where I used my business knowledge to help develop software companies, businesses, and products, and also encourage customers to take leaps into new technologies that would enhance or improve and in some cases forever change their businesses. And it’s been fun.

Ali Curi: Alex, what are some of your job functions in your current role, and what’s one exciting aspect of your job?.

Alex Lamb: Currently, I’m responsible for marketing certain products, um, and helping build messaging around those products by leaning on my experience and leaning on the experience that others within the organization that I’m working with can help me with.

Uh, and it’s exciting because there are so many opportunities for those products to be assisted, merged, combined with other similar or even disparate products. So for example, we have risk management being combined with, uh, surveillance, or we have risk management for derivatives on trading, on exchanges being combined with risk management for OTC products.

It’s the novelty, for example, of that last one. That I think is what keeps me wanting to rush in to work in the mornings that when you get these interesting juxtapositioning, the removal in some cases of these blocks or walls between these instrument classes and also, um, starting to look across the fence to not just their derivatives and over the counter derivatives, but also at commodities, uh, foreign exchange, and treasury functions. They all hook together in some way. And I think, uh, it’s exciting to be in the place where you can take advantage of touching all of those. But I said at this point I’m, I’m just dealing with a smaller part, which is risk and surveillance.

Ali Curi: Let’s talk about something that you’re very familiar with, which is the trading life cycle. This is a process that’s been around forever or at least since modern trading started. From your experience, what can you share with us about what’s new or challenging within the trading life cycle?

Alex Lamb: Well, what’s new and challenging, and it, it’s always the case, is the fact that the volumes of trading transactions keeps growing. The good thing is, along with those volumes of transaction growing, the ability to predetermine the end customer account or to get the end customer to self service, the trading activity is so much easier today than it used to be. So the trading life cycle begins with the end user making a decision to buy or sell something. And as before, that order has to then be processed so it sits on his account and, uh, is settled in the appropriate manner. The old days, it would be simply a bookkeeping entry followed by, um, a demand for either a margin and, uh, some extra cash in case the margin went the wrong way. You would then wait until the client called you and you traded out of it, and then the process would be done again.

Today it’s very different because, millions of transactions can flow through one sell-side institution, and those millions of transactions all start from thousands of origins, flow into hundreds of markets, then get returned from those hundreds of markets by either enriched fully, in which case they go the zipping through whatever middle office systems are there to monitor and check and straight to the back office system where they are uploaded and booked to the relevant account, and that account will then be debited or credited with whatever the outcome of the order, should I say in this case, trade is. The others, which are still a big number and certainly in March of 2020, caused a massive problem for a lot of firms and the clearing houses involved in the trades are unallocated trades or partially allocated trades and these partially allocated trades, again, most of them could be fully automated through to the back office, and in many cases they are because the easiest way to do that is to say, we’re gonna carte blanche accept these trades, um, from the other brokers, and we hope that the other brokers will accept the trades we send to them that were executed on our books. And then we hope that we can monitor at the end of the day whether or not we’ve sent them too much, the wrong things, and vice versa, that they’ve sent us too much or not enough, maybe some of the wrong trades, and we’ll square that away. Well, that squaring away process in March of 2020 was sometimes anywhere between 24, 48, and 72 hours.

And in 72 hours in the market, I don’t care which market it is, the world can change and, uh, the potential risk, either loss or massive profits on your books that you then pay out against, which perhaps, uh, didn’t illustrate the losses that weren’t booked could be, uh, dramatic. And so what was clear from various surveys that took place around that time and also some commentary through, um, industry associations was that many of these firms knew that this process, front to back, had to be improved. How you improve it and which piece you improve, that’s the challenge because most firms have a different approach to this life cycle. The end result is the same. Somebody buys, somebody sells, Somebody pays. Somebody receives. That’s the end result. It’s very simple, but what happens in between can be extremely complex and sometimes, uh, can present you with unwanted risk.

Ali Curi: Along the same vein of discussion in terms of processes, right? Every firm has to wrestle with the fact that there are outside influences that affect the trading life cycle, which they can’t control. But going back to what you were saying about processes that can be controlled, what are some processes that firms can control or improve upon fairly quickly?

Alex Lamb: Today, firms can control them, but the bulk of those controls have to be manual in many cases because of the complexity of the post trade allocation processes, and of course the waiting time in the case of some trades, so for example, an average price order trade may take all day to execute, and until that average price has been reached on the last leg of that transaction, you don’t know what the average price is so you can’t give it up and allocate it to the destination until that’s happened.

But meanwhile, maybe thousands of contracts that will be part of that final order are sitting on your book waiting to be given up, and they have a risk value. And until that give up has taken place, they are your risk because the recipient may turn around and say “I’m not taking those, they’re going to break my limits.” And again, those are manual processes.

So I think the biggest risk in terms of the transaction life cycle, the trade life cycle, is in fact that give-up give-in process failing or being extremely slow and a customer or in-house account within that chain being discovered to be in breach long after the breach has taken place and long after the available cash for that account has perhaps disappeared.

And a way to mitigate, that’s the one area I think that many people will agree is the best place to, or a good place. Um, most people look at their intra day trading risk that their own traders or their connected clients clear through them. Present through their trading as being a big risk. But I would conjecture that it’s actually potentially bigger.

In 2020, a large European bank lost $200 million because one of its funds wasn’t adequately funded on its books, and they didn’t know that until that day. And why didn’t they know it? Because they didn’t necessarily see the trades that were gonna land on the books until it was too late and they didn’t reject the trades in time.

So there was no way they were going to be able to control those trades from happening because they were being executed somewhere else. And as a result, um, a, a large loss was taken, uh, I believe that clearer managed to draw back some, if not all, of those losses, but again, why impact your business by having to deal with problems after the event?

So the automation that we could see is the ability to evaluate an incoming trade for a give-in. Evaluate an outgoing trade for a give up based on certain criteria so that you can make an educated guess that that trade is going to go where it’s supposed to go and it’s not going to cause your firm a problem. Bringing checks into that particular process that are relevant to not only the transaction values, but also to the portfolios that result from those transactions to be able to estimate how big the overall exposure would be if we accept these trades, how big the overall exposure would be if the other side didn’t accept these trades.

We’ve actually got customers who use our risk management platform to evaluate that in-house risk that they don’t want to have on a continuous basis using a snapshot evaluation.

Um, and it means that when they do that evaluation and they see the numbers, they can go to the participants and go, hold on a second, you need to stop trading and you need to take trades. And if you don’t do that, then we’re going to have to cut you off. Extreme, but in some cases, essential.

Advert: This episode is brought to you by ION.

At ION, our cleared derivative solutions automate your complete trade life cycle and deliver actionable insights whenever and wherever you need them. We offer execution and order management, post trade processing, and a complete front to back business solution. To learn more, visit us at iongroup.com/markets or email us at [email protected].

Ali Curi: Let’s talk about margins. Everything eventually leads us back to the trade life cycle and performance bonds, right? Margins. How do different types of margins affect the profitability of trades?

Alex Lamb: The profitability of a trade is only affected in reality by the variation margin. How much you make or lose on a trade relative, the shall we say, the current price that you perceivably could close the trade at. That in itself, it generally is thought as being the biggest component in shall we say, risk exposure in a, in a trade. But with the way markets have been so volatile, which I would say, uh, for some of us, uh, isn’t just recent history. Um, I came into the sugar markets when sugar moved on average 10% in a week, and initial margins in those days were woefully inadequate. How we didn’t go bust three or four times, uh, was incredible.

But today, initial margins are calculated very carefully in order to try to limit the exposure of the firm that either owns the trade, in other words, the customer, and the firm that holds the trade, the clearinghouse, or the sell side broker, in order to make sure that that trade doesn’t break any one of these institutions.

Initial margin valuation is done by the central clearing counterpart at one level and potentially increased by the broker at another level and funded by the customer by having adequate collateral, cash, or equally profits on other accounts to offset that particular potential cover.

We talk about initial margins as being the insurance or the earnest money in the transaction, and that earnest money has to be adequate to cover an average day move. Well, we don’t know what an average day move is at the moment. If you look at the way the energy markets have been flying around, and the way, um, the financial markets have suddenly moved after a decade or more of inaction.

We are seeing new young traders whose trading style evolved in times of quiet stability, being shocked that they’re having to deal with crazy markets.

Ali Curi: You know, that’s a really good point. I’m gonna ask you the following question because you know a lot about a lot. And one thing that I’ve been reading about recently is performance premiums.

First of all, can you explain what they are and talk about how initial margins can serve as insurance of performance.

Alex Lamb: The fact that the initial margin is part of every transaction that takes place and is, is part of the regulations that the self regulatory or organization in this case, uh, central counterparty has put in force and their ability to modify those on the fly on demand. This is about the most flexible form of insurance that you can imagine because you and I, we go and buy a car insurance, um, for a certain number of risks. We maybe don’t have any problems. We renew, the cost is about the same, or we have two problems and we renew it at the end of the year, and the cost is enormous.

The difference here is the performance of each order has to be guaranteed by the central counterparty, regardless of how volatile the markets are, um, and how expensive, um, those swings in the markets make potential losses. And so the bigger the potential losses due to big swings. Those potential losses will be exacerbated by the size of the open interest in the marketplace and by the size of the market.

Some Asian markets look at the amount of traded volume on the previous day as a trade order limit. That they’d like to impose on people playing in the markets on the next day, as well as charging an initial margin. Uh, mainly because they don’t want to see people suddenly trading masses of amounts in a particular instrument without there being enough safeguards in place.

So that’s one approach that the central counterparty can take. Other central counterparties say we’re not going to, you know, stop people from trading any amount they want to. But when they get to a point where their positions are large, volatility’s high, we will charge enough money to cover a day’s risk and in some cases, enough money to cover the second half of the day’s risk or the next quarter of a day’s risk.

So we’re, we’re actually moving towards a point where earnest money is being demanded of participants. As soon as the, the perception that this is a riskier position than normal is reached and the exchanges start that ball rolling by making special margin calls on a particular instrument set.

Now the clearer the market access provider, the futures broker if you will, uh, or securities broker, can offset some of the risks that their customer has by saying, okay, he’s got a big risky position in this instrument, but those instruments over there where he’s got tons of profits and there’s not much volatility and there’s some kind of negative correlation, um, I can use some of that in my risk model to say, okay, we’re going to be a bit lenient on how soon we call the margin or whether or not we add to the buffer zone because again, people don’t trade up to the last dollar in their account.

There’s always a buffer amount in their account to ensure that margin calls will be met if, for example, there’s a breakdown in communication. The guy that you’re calling, uh, is on a plane and he’s the only guy authorized to make the margin payment. That can happen. So again, knowing your client is extremely important and the industry of KYC as part of the client or onboarding thing has also taken off rapidly because while we can put everybody in a box and say, this is, this is your profile, nothing beats knowing who your customer is as well as knowing your customer’s, real financials.

Ali Curi: Let’s change gears a little bit. Talk about front to back office. So this process ties everything together, right? The trading life cycle, and it’s the industry norm. But often when front to back is discussed, it’s usually around its legacy systems and its inefficiencies. Where do you see room for improvement in front to back processing?

Alex Lamb: I think it probably starts with uniformity in instrument data, in message data to perhaps move everybody towards a, a single standard in what really is the lifeblood of markets, which is the transaction. Now, FIX trading has gone a long way to getting everybody onto the same messaging standard, so a lot of the messages that flow through all of these firms already standardized in FIX, which is great.

But the challenge still exists, that there are so many different master data profiles, uh, instrument repository catalogs, if you like, that are unique. They should all be unique, but are unique to exchange A, exchange B, exchange C, that are sometimes manipulated by back office administrators and have been in the past to, you know, work around something that isn’t readily accommodated by this system.

And as a result, a lot of the legacy issues that people come up against are old codifications of workarounds that don’t fit into a modern architecture. And so getting those legacy workarounds out of this application or that application and replacing it with a structure that is not only, shall we say, logical for everything that you’re going to touch in your trading life cycle. And I think, again, people will agree that today, any trading life cycle, literally for a global brokerage company that’s in derivatives will have hundreds of thousands of instruments, and among those hundreds of thousands of instruments there are going to be many lookalikes. And what you want to be able to do is integrate a system readily and quickly without having to spend days, weeks, months, trying to figure out how to map instrument A in my language to instrument A in the clearinghouse’s language, to instrument A in my back office system’s language, and then instrument A into my recipient on the give up language. And so I have this potential risk with every project that I’ve got, multiple interfaces that I have to align in order to get things to talk to each other.

And what we really want to do is be able to say, Okay, here’s a master data mapping kit. Um, if you are not on the new standard, run everything through this. This is what your interface has to look like. This mapping kit will convert things, and then down the road you drop the systems that are old and don’t immediately interface. And, uh, as a result, we have a common language. We’re not having to translate anything as we add new titles. So if we use the analogy of language, new books, understanding those new books and being able to, um, interpret those new books becomes easy because you don’t have to start by translating them. And as we know, lots is always lost in translation.

Ali Curi: Well, I think that’s, uh, that’s a great roadmap for those looking to upgrade their legacy systems. I mean, it’s, it’s a short, condensed version, but nonetheless, it’s a useful tip.

Before we close out, Alex, I would like to change topics for a minute and ask you to share with our listeners what is some advice you wish you had heard earlier in your career?

Alex Lamb: I wish I had learned more about the independent approach to being a business within a business. Some of my colleagues figured this out before I did. I’ve always tended to be an employee, so I think, I think understanding what the opportunities are. I think when you come into the financial markets, businesses, you need to understand what the opportunities are.

Pick up as much information as you can, and be as flexible as you can be in order to discover those opportunities and then exploit both for yourself and the people that you’re working with.

Ali Curi: And for those interested in developing their careers in, say, software development and financial services, what advice do you have for them?

Alex Lamb: Starting one and move into the other, and vice versa. If you’re going to be in the technology financial services, it’s helpful to understand the business equally, if you’re in the business, it’s also vitally important that you understand the technology. So understanding how these processes work, I think is gonna be key to being in a good position to work your way up the business chain, whether it’s as a developer or whether it’s on the business side, whether it’s selling products, working with products knowing both is probably the best thing you can do.

Ali: Well, Alex Lamb, thank you for joining us today. It’s been such a pleasure having you on the podcast.

Alex Lamb: My pleasure to be here. Thank you so much for inviting me.

Ali: And that’s our episode for today. You can follow ION Markets on Twitter and LinkedIn. Thank you for joining us.

I’m Ali Curi. Until next time.