SEC Risk Proposal: A Fair Start But Lacking Specifics

The SEC risk management proposal advocating baseline operational risk controls at brokers and broker/dealers is a good-faith attempt by regulators to augment the risk management function within brokers and broker/dealers. The proposal largely advocates pre-trade controls and procedures to avoid trade input errors, which can result in significant financial loss to a firm and potentially excessive risk to the operation of the aggregate markets.

These controls and procedures would be implemented across a firm’s proprietary and agency businesses including sponsored and naked access offerings. However, in the proposal, the SEC leaves too much discretion of acceptable practices to the discretion of the firms whose activities require control. It is almost like the SEC saying to firm management “you really should examine your existing risk management infrastructure. If you think it is substandard, improve it.

But we’ll leave it to you to determine what needs to be done and the resources that need to be devoted.” That is a recipe for inconsistency across the industry, ambiguity as to what constitutes “generally acceptable” controls and procedures, and inconsistent enforcement.

The SEC would better serve the community to break with tradition of “guiding” the industry and, with input from practitioners, developing and mandating a uniform, baseline set of risk controls and procedures applicable to all firms that trade on exchanges directly or provide sponsored access to others. This would, at minimum, remove the discretionary elements in bolstering risk management practices within the industry and enhance the control of firm-specific and systemic risks.

Risk management is a critical but often overlooked and undervalued aspect of business in the capital markets. Though enterprise risk management has been commonplace among banks and broker/dealers since the early 1990s, there has been no shortage of high profile incidents since that time. While most sizable events have been particularly localized to one (or few) firms, everyone is familiar with last year's systemic credit market melt-down.

Why do these events continue to occur when firms have risk management infrastructure in place?

The answer rests in market forces. Most capital markets professionals understand that risk and return are intertwined. In principle, the greater the risk associated with a strategy or business, the greater the potential return that should be generated. Compensation in line business areas at brokers and broker/dealers is usually based, directly or indirectly, on top line revenue. The lure of potentially greater compensation drives professionals to undertake business practices to generate greater revenue and this normally results in the business or firm incurring larger risk. There is nothing sinister about this mechanism. It is the principal by which businesses within the capital markets (and other industries) operate to maximize the drive for revenue and profit. Welcome to capitalism.

Financial gain and loss are probabilistic and occur in the future. After all, if losses were incurred at the time a decision was made to enter business or a financial position, no one would do so. With an eye focused on gains, stepping back and fully considering the risks of a strategy or business may become of secondary consideration. Even when it isn’t, a truly unbiased view of risk and return is often not possible when one has a vested interest in the outcome. Spread across businesses within a firm and firms across a market, systemic risk can become substantial.

Risk management controls and procedures are established within broker/dealers and other financial, in principle, to keep the risks incurred by line businesses in line with a firm’s “risk appetite.” Risk managers, however, are continually challenged within firms by business interests that want to push risk limits for the reasons addressed above. It can be daunting for the risk manager to stand against well-situated, senior-level revenue generators and business managers, since risk cannot be quantified with certainty. Add to that the paradox that a risk manager is successful when nothing happens. No question, it is harder to justify budget for a practice that guards against a low-probability potential loss than it is to fund a business that continually generates superior revenues.

View the entire Woodbine Opinion.

About the Author

Matt Samelson is a Principal at Woodbine Associates, specializing in equity market structure, trading venues, electronic trading, and transaction cost analysis. He has a wealth of experience in U.S. and international equity sales and trading, quantitative analysis, consulting, and research. He has in-depth knowledge of trade strategy formulation, algorithmic trading, market structure, transaction cost analysis and trading technology.