Applying Exchanges’ Risk Measures Broadly Across Markets Will Support Post-Pandemic Rebound

Over the past decade, the securities trading industry has responded to economic and operational crises with a series of circuit breakers, limits and risk controls, implemented one at a time. The COVID pandemic crisis that began in 2020 has highlighted the need to enhance these measures and put together a comprehensive, connected set of tools to decisively reduce market risk.

The financial industry should take these three actions to achieve this goal:

• Establish limits for each trading participant firm at self-regulatory organizations (SROs).
• Develop more quantitative risk controls to detect abnormal trading behavior in real time.
• Evaluate how and if a longer-term consolidated control mechanism should be established.

Let’s walk through how to go about taking each of these actions, and what has already been done.

Efforts are underway to strengthen market risk controls, writes DTCC’s Michele Hillery

SRO Limits for Member Firms

Establishing SRO limits for member firms that limit overall and/or categories of activity would be the next step in a decade-long evolution.

In 2012, a Knight Capital technology glitch resulted in $440 million in losses, and spurred the industry to bring together a working group of exchanges, SROs, broker-dealers, buy-side firms and clearing organizations. This collaboration led to the launch of DTCC Limit Monitoring, a risk monitoring tool, implemented in 2014 by National Securities Clearing Corp., DTCC’s equities clearing agency and central counterparty subsidiary. This provides NSCC member firms with a self-managed risk management tool through which they set their own trading limits and receive alerts when those limits are close to being met.

DTCC Limit Monitoring also delivers the largest aggregate trading information available for the U.S. equity markets and provides the industry with a holistic view of all transactions across equity trading venues compared to its pre-set trading limits.

In 2020, three major U.S. exchanges – NYSE, CBOE and Nasdaq – installed pre-trade risk controls that give trading members of these exchanges and their clearing firm a way to view, set and monitor risk controls. The pre-trade controls also allow “kill switch” actions, which detect and cut off trade orders that violate pre-set or required limits. Such orders can occur when an algorithm or trading platform malfunctions. DTCC worked with these exchanges to set trading venue standards and risk controls to mitigate risk in order flow coming to those exchanges, to a more effective degree, similar to what occurs in U.S. options and futures exchanges.

Using this completed work as a guide, additional exchanges, clearing venues and SROs can implement similar risk limits that will make the limits and controls more consistent and uniform throughout all markets.

Pre-Set Quantitative Risk Limits

In 2020, U.S. equity exchanges set out several quantitative risk controls that can serve as a standard for detecting abnormal trading behavior in real time. While market participants would still be required to know what limits and tolerances to set in each of these risk control categories, these mechanisms provide an additional level of risk management.

Along with the previously mentioned trading limits and kill switches, equity exchanges set single order quantity limits, single order notional value limits and gross credit limits. These limits also include certain intraday position limits for gross and net amounts at symbol and portfolio levels.

Limits may be modified in real time if necessary, and clearing broker-dealers may submit instructions to halt activity, discontinue clearing of trades and reinstate a market participant in real time. Of course, under these risk controls, the exchanges can now reject orders that are above these specified limits, block further orders and cancel open orders from those market participants who have exceeded those limits.

Going forward, these risk controls create a more secure foundation, but additional risk controls can be introduced to allow the industry to more quickly detect abnormal trading behavior in real time.

Clearing Agency Control Mechanisms

To continue strengthening market risk controls, additional considerations are in discussion across the industry. To continue improving controls put in place by exchanges in early 2020, similar controls are under consideration by clearing agencies to address the growth in off-exchange trading venues. DTCC has collected proposals to reduce risks with respect to off-exchange activity. These include:

• Requiring inclusion of market participant ID when submitting trades. Previously, NSCC trading relationships only required inclusion of clearing broker IDs for both parties in the trade.
• Including gross notional limits at the agreement level for NSCC’s trading relationship management (TRM) system. This proposed enhancement would allow modification of these limits in real time.
• Expanding NSCC’s universal trade capture validation criteria to include gross notional limits. This proposed enhancement would identify transactions that are submitted beyond those limits, giving submitting firms until the end of the trading day to meet the required notional value limit. If a transaction has failed to meet that limit by the end of the day, it would be canceled.
• Expanding alternative trading systems (ATSs) controls on front-end platforms to include gross notional risk checks. Exchanges have already implemented these types of controls, so this proposal requires ATSs to meet that same standard.

As DTCC takes this discussion further with key stakeholders across the industry, any changes that are approved will be made in accordance with industry feedback and implemented in line with recommendations.

This industry continues to evolve to ensure optimal risk management capabilities and resiliency. Accepting and implementing these proposals could assist in closing gaps in the market risk standards that have already been accepted by many major trading venues. These methods would help identify issues more quickly and reduce the risks of problematic trades or transactions being confirmed, leading to increased safeguarding of the industry and individual investors.

Michele Hillery is general manager of equity clearing and DTC Settlement Service, Depository Trust & Clearing Corp. (DTCC)