REAL-TIME RISK: NEWS

What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes

#RealTime #Risk and #MiFID II

By Steve Krawciw

MiFID II is projected to take force in January 2018, and most financial institutions touching European financial markets will be subject to the MiFID II rules. MiFID II touches many areas of financial practice: trade execution, investor communication, risk monitoring and control, governance and reporting, as well as margining and fiduciary limits. Many of the practices mandated by MiFID II bring trading, risk management and compliance functions in line with technological innovations in portfolio management. These innovations are driven by the adoption of big data strategies and plummeting costs of technology, as described in our new bestselling book, “Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes” (Wiley, 2017).

 

Specifically, MiFID II attempts to push financial institutions into the 21st century: speed up accountability, risk management and reporting to match, or at least, approximate the speeds deployed by their portfolio-management brethren. Specifically, MiFID II expects companies to organize their risk management along two pillars: 1) setting limits based on pre-determined tolerances, and 2) produce real-time surveillance based on limits set in 1).

 

How does one even begin to determine tolerances? A good start is to understanding a whole new universe of risks associated with malfunctioning or “run-away” computer programs, known as algorithms, and liquidity deficiencies that cause flash crashes, not to mention malicious activity causing intentional havoc in the markets. Many of these new risks, as well as the intuition behind estimation and surveillance of these risks, are described in plain English in the “Real-Time Risk” book.

 

How severe can these risks really be and what do financial services companies stand to benefit from measuring something like the probability of a flash crash? It turns out, a lot. AbleMarkets is a Big Data for Capital Markets company, one of whose products happens to be the Flash Crash Index, a probability of flash crash in a particular financial instrument expressed from 0% to 100% a whole trading day ahead. These estimates are accurate and are based on the cellular-level metrics of financial markets’ health: its market microstructure parameters. If a probability of a flash crash is high tomorrow in a given financial instrument, say IBM stock or oil futures, selling IBM or oil the next morning, instead of spreading the transaction through the day, delivers as much as 27% extra return per year. Why? On a day when there is a higher probability of a flash crash,, the probability of it actually happening increases as the day progresses. The probability of a flash crash on the day prone to a flash crash is thus lowest in the morning, and that’s when it is the best time to sell the financial instrument. By surveilling the markets and taking note of flash crashes, financial institutions of all stripes indeed stand to gain substantially from the new technology.

 

And from the perspective of protecting financial stability, firms benefit tremendously as well. If you know that a flash crash is likely in a particular financial instrument, won’t you be better off limiting your customers’ exposure in that instrument a priori? Whether setting limits or increasing the flash-crash-dependent haircut on the collateral, understanding the risks of such events allows financial institutions to become more profitable in the end.

 

Of course, flash crashes and related real-time liquidity risks are not the only new risks in existence. As discussed in “Real-Time Risk”, many of the risks are a byproduct of our daily reality. For example, stocks discussed on social media experience greater volatility (yes, AbleMarkets also tracks social media chatter), and aggressive high-frequency traders (HFTs) erode liquidity leaving slippage and volatility for other market participants in their wake. Thanks to Big Data and technology, however, most of these manifestations of real-time risk are measurable, and soon, with implementation of MiFID II by financial institutions, will be fully manageable.

Steve Krawciw is an expert on Fintech strategy, a co-author of “Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes” (Wiley, 2017), and Managing Director and CEO of AbleMarkets, a big data for capital markets company. Prior to AbleMarkets, Steve launched over $4 billion of products for Credit Suisse over a 7-year span. Previously, Steve ran asset and wealth management initiatives for CIBC, and consulted for McKinsey and Co., and Monitor Consulting. Steve had an honor of working for President Mandela of South Africa. Steve holds a BComm from University of Calgary and an MBA from Wharton School at University of Pennsylvania.

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