With tens of thousands of spread bets made in the UK every day on a range of financial underlyings, good risk management is vital for spread betting firms. Alexander Campbell talks to Andrew Bole, risk director at IG Index.
IG Index, the UK's oldest spread betting company at a venerable 32 years, has moved from being a small bookmaking operation concentrating on the gold market (the original name was Investors' Gold Index) to a listed company offering spread bets on thousands of underlying financial assets, from equity indexes and single stocks, to currencies and commodities.
The company's expansion has put it closer to the investment banking world - and, like an investment bank, it takes risk management seriously. Andrew Bole, risk director at IG Index, is responsible for managing the company's exposure to its punters.
Client insolvency risk and market risk are the main dangers for a spread betting firm, and each requires different tools to manage the exposures. Bole explains that his main defence against insolvent customers is prevention. "For example, if a client has a diversified portfolio and trades mainly indexes, you are much more relaxed than if a client takes one position in an Alternative Investment Market-listed telecom company and wants to build a large stake."
Bole's risk committee - along with the sales and product management teams - is continually assessing the exposure each customer represents. Clients are rated depending on their portfolio's concentration by asset type and by country. "If a client is based in Russia, for instance, they get a higher score for being in Russia because there is a country risk. If they only have one position on their account, and it is in a volatile area like silver, they will appear as a higher risk client," Bole says.
Once a client's risk profile increases, IG will put out a margin call - but this has to be done tactfully. "It may be just a conversation - we may ask the client to provide evidence to support the position. You need to apply some common sense and appreciate the value of the client," explains Bole. "We can say to clients 'these are the things we want to do and this is why we are doing it'. It is a much more grown-up conversation than just 'we'll put your margin up'."
As counterparty to thousands of spread trades every day, from small punts to large trading positions, IG Index has to manage a significant amount of market risk. But hedging every spread trade as it is placed is not practical.
There are two ways around this problem. First, in highly active markets, many of the spread bets cancel each other out. "If it's a very busy market, you will have a lot of two-way business, which is ideal. We are just acting as another market-maker," says Bole.
However, in less liquid markets, such as spread bets on single stocks, IG Index cannot rely on investors taking both sides of the market. Instead, it hedges its exposure using futures on the underlying stock. This is simple in principle, but the introduction of foreign exchange risk increases the complexity - a UK client might trade an overseas equity index but would expect payment in sterling. "The key part is working out what the underlying equivalent is (within our exposure model), and then you can use the tools available within the normal financial markets," Bole explains.
Keeping an eye on IG's exposure, the risk committee uses an approach that would be familiar to any fund manager - employing limits on individual underlyings, sectors of the markets and countries, in what Bole calls a hierarchy of exposure.
"If all your clients were long, you could arguably be inside your limits, but you could have massive exposure to the UK stock market as a whole. So, in that case, you would hedge on futures on the index. Or, if you are concentrated in a banking sector, you can review that sector - so you're building up a much better portfolio picture," he says.
However, standard risk modelling techniques such as value-at-risk are unusable by IG Index, he says. "The problem with a VAR model is that it needs inputs. When you talk to an investment bank about VAR, they say they run it on their interest rate swaps portfolio or European interest rate swaps - it is quite a defined portfolio with a small number of inputs. If you are talking about trying to input 8,000 or 10,000 products into your model, it loses its relevance - there's too much data to influence it. It just isn't a valuable comparison."
Originally published on Risk Magazine
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