March 9, 2019
Regulators shall be careful to make sure banks risk management desk is not secretly prop trading. One example is central risk book.
Most of banks central risk book argue its job is systematic internalization.It acts a dealer between two counter-parties. Some CRB try to expand its function to automated market making by talking directly to clients . The biggest problem is flow toxicity. Nowadays, client like to choose agency algo given its low commission. When they come to CRB, they knew it is a order hard to trade. Such adverse selection caused central risk book lose more money when they trade more. Some banks hedge through portfolio optimization. But given toxicity of their book, they lose more money when they hold longer. Yes, that include proxy hedging using ETF or future. Electronic IOI is another attempt. But client consider most of sell side IOIs as spams. Regulators shall regulated IOI just like regulating spamming emails. Client do like natural IOIs, that means dealer hold similar position as client so market impact is minimal. lots banks CRB is tweaking parameters to create more natural IOIs. This behavior itself is a grey area given nowadays regulators do not pose strict governance on model parameters. Some banks central risks book trader can arbitrally modify also parameters with little control. Given toxicity of central risk book, it is more likely be affected by tail event than any other desk. It is one of under regulated area. you see lots of former prop traders in banks central risk book. Because these traders want to misuse client data. Within central risk book, you get access to tremendous amount of client data. Some people in central risk book, usually people who were previously prop traders or who worked in buy side tried to reverse engineering client behavior. Once they find a robust client trading pattern, they will use these knowledge to exploit clients through front running after they leave team. Regulators need to make sure client data is safe and nobody use client data to create trading strategy to front-running clients.