Market-makers need to get technical

The concept of assessing the risk versus reward of certain types of trades has received increasing attention in the past couple of years. This is not least because of the emergence of latency arbitrageurs in eFX that took advantage of delays in receiving fresh pricing by some banks over others.

As banks cut off liquidity to clients that were not delivering margin, some went further to build ways to systematically measure and capture profitable flows. Deutsche Bank claims to have developed tools to enable it to distinguish between flow that is profitable and that which is not. Similarly, Lehman Brothers has a robust automated risk and liquidity management system in place.

The need for this type of technology is becoming ever more crucial not only because of highly volatile market conditions, but also because of the projected growth in volumes from retail FX traders. Banks need to ensure they have systems that can manage trading to capture any immediate spread from clients and any netting opportunity, systematically and measurably. The measurement processes could also be used to calculate the value of trading flow against each trade.

Based on a probabilistic view, these automated systems can then make money for the bank, and likely at times lose money too. But the bank will be able to measurably assess flow to ensure that it is not just taking on volume for volume's sake.

Justyn Trenner, chief executive at client strategy firm ClientKnowledge, said only a limited number of banks have effective automated risk management of their flow. He said market-makers must set up appropriate liquidity management systems to ensure they are only making prices that reflect the interest they have that will enable them to make money. "It's about having the right automated risk management/liquidity management systems in place to allow you to do that."

The past few weeks certainly exposed technological and model risks. Banks that were unable to change their parameters in real time would have been at a disadvantage. These parameters include those for risk, pricing, update frequency and hedging parameters across all the different clients and risks.