rules

trading strategy index exception handlingTrading Strategy Index Exception Handling is an important aspect of the Index rules.  They are purely systematic and do not contain discretionary elements. This allows investment banks and other brokers to offer these products to clients without having to acquire an asset management licence.
This sounds easy enough, however, coming up with rules that cover all possible cases and exceptions is more complex than meets the eye. Unlike rules for a trading strategy applied by a trader for a discretionary portfolio, it is not good enough to cover 80% of the cases and ‘wing it’ if necessary, once the rules no longer cover the situation. Even though this approach simplifies the rules creation process significantly and improves their readability, this can be interpreted as a discretionary element.

 

From a practical point of view, rules that do cover most cases and let the bank act in good faith in all other cases, could be a sensitive alternative. However, this is not how regulation works. Trading Strategy Index Exception Handling is a crucial aspect of best practices and regulatory compliance.

In an investment product that is sold to the public/qualified investors, this discretionary element can mean that a strict regulator (or compliance department) demands immediate action. Either doing an immediate update of the rulebooks or to stop dealing with such products. In the past, a number of banks were not very strict with their documentation, this is causing some headache now.If the nature of these exceptions is not clear, let me give some examples. Trading Strategy Indices and also standard index daily values are usually calculated using the closing price of the underlyings. In the case of a market disruption there may be no closing price, so there is the question how to deal with this.

  • Should a level for that day be published at all?
  • If yes, based on what?
  • Will they be previously published levels changed, once the disruption is over?
  • If the market is no longer disrupted, will there be some sort of backfilling of levels?
  • What if the disruption is for more than 1 day?
Extended market disruption is not common in equity and fixed income markets, but happens more often in the commodity sector. Rules that do in effect cover 100% of the cases need to answer the question of what happens on the fifth day of a market disruption or if a security is discontinued.

It is also worth mentioning that there is some reputational risk involved in dealing "in good faith". Even with the client's best interest at heart, the decisions made may still result in the client losing money. Unlike in the case of a purely algorithmic process, this can result in serious PR issues.

For providers of financial products it is crucial to have impeccable documentation of all offered products. Ambiguities and flaws in such documentation can give clients a free option to litigate in case the investment turns sour. This can cost costs banks a great deal of time, money, reputation and management capacity. Again Trading Strategy Index Exception Handling prevents all this.

In a world of ever more stringent financial regulation, there is little scope for less than complete complete rules on Trading Strategy Indices. Smaller and newer strategy providers may need some outside help on best practices, regulatory requirements and possibly on drafting the rules. This can come from law firms or other specialist providers in this field.
Share Button