Jackson warns banks of 'Frenemy' counterparty risks from trading firms
Rebecca Jackson of the Bank of England warned that Principal Trading Firms, while clients, also pose significant counterparty risks to banks. She highlighted how proprietary trading risks have transformed into indirect exposures for the banking sector.
Frenemies: Competitors and clients
Principal Trading Firms (PTFs) have become established liquidity providers, competing fiercely with banks in electronic trading venues for segments like FX and credit.
Despite this, PTFs rely on banks for crucial services such as financial leverage, clearing, treasury, payments, and market access, defining them as 'Frenemies'.
While major investment banks largely exited proprietary trading post-crisis, these risks have transformed.
They shifted from direct proprietary trading risks within banks to indirect counterparty risks, as banks provide essential infrastructure and guarantees for PTFs' market-making activities.
This exposes banks to PTFs' proprietary trading risks through their service provision.
The 'Kill Switch' dilemma in high-speed trading
The high volume and velocity of Principal Trading Firms' (PTFs) intraday activities increase banks' counterparty risks, as servicing banks guarantee settlements.
PTFs often bypass banks' pre-trade controls by trading directly on exchanges, forcing reliance on slower post-trade monitoring.
This creates a 'response gap' due to ultra-low latency: detecting issues takes seconds, human response minutes.
The 'Kill Switch' to halt erroneous trading is complex when PTFs trade directly, relying on PTF self-detection or remote activation.
The 2012 Knight Capital incident, where a coding error caused $500 million in losses, proves these 'runaway algo' risks are real, not theoretical.