Liquidation Risk: Have you assessed the impact on your firm?

As market volatility persists, brokers have become increasing vigilant monitoring the risk of their clients’ potential (and realised) negative balance exposure following liquidation, but there is another side to liquidation risk that may be even more important for brokers to consider.

Liquidation of the broker’s account with their Liquidity Provider could constitute an even more dangerous event, as it leaves the broker both fully exposed to market risk and, for brokers required to be 100% STP, this can in some cases create regulatory concerns.

The best protection from such an event is, of course, proper collateralisation of their account but, as well as this, there are some other factors brokers need to evaluate to provide themselves with the maximum possible protection.

Why brokers should review liquidation terms

First and foremost, brokers should review the specific liquidation terms for their accounts. In most cases, liquidation of all positions is automatically triggered by the trading platform at a specific margin threshold – often 70%. This type of arrangement leaves a broker with no opportunity to react following a swift market move, or if a new client gets a little ‘trigger happy’;  it results in the complete removal of the protection provided by a broker’s hedge positions. 

Alternatively, some Liquidity Providers will either allow a broker to scale out of positions to correct the margin deficiency and/or place the account on margin call and provide time for additional funds to be deposited. The key difference is that a systematised full liquidation leaves the broker with no opportunity to respond, and therefore at most risk of a full liquidation event occurring.

Largely in the true institutional/Prime of Prime world it is not in the interest of an STP Prime of Prime broker to liquidate a client’s account. This is because there is limited upside – all they will make is a relatively small amount of commission/spread from the close trades. It is only really in the interest of a broker running a B-book to stop-out clients as they will be significantly better compensated by keeping the client’s margin over a liquidation event. 

Due to this, most truly institutional Prime of Primes will not have an auto-liquidation level. This allows them to work with broker clients to manage exposures and to prevent a stop-out from occurring with the procedure often being that the client will only be able to enter into ‘risk reducing’ trades, i.e. those that lower their margin utilisation.

The importance of understanding liquidity provider policies

Another factor to consider is the Liquidity Provider’s policy on changes to margin requirements. In market conditions such as the ones we currently face, Liquidity Providers are at times required to increase requirements for certain instruments to mitigate their own risk. The important consideration for brokers is the amount of notice that the Liquidity Provider gives before making such a change. An instant increase in the requirement on a large position can immediately trigger a liquidation event.

The need for ongoing due diligence

Liquidation of hedge positions can be a catastrophic event, so brokers need to make sure they have done the due diligence necessary to make sure they are as protected as possible. As no one expects a liquidation event to occur, the specific contract terms that dictate the cause and form of the liquidation are often ignored. Now is the time for all brokers to make sure that is no longer the case.

Ultimately brokers should be working with an LP whose interests are aligned with their own and must ensure they are asking the right questions to ascertain this. 

At IS Risk Analytics we work with brokers of all sizes – from small 125k STP brokers to some of the world’s largest brokers running A-book, B-book and hybrid models. Our experience with these institutions, as well as their wide and varied Liquidity Provider setups has given us a unique perspective to advise their management and dealing teams on the best ways to protect their businesses. 

Speak to the team today to discuss how we can help your firm protect itself from the significant and very real risks of a liquidation event.