12/03/2014 02:03 pm ET Updated Feb 01, 2015

Microstructure Risk Is a Key Measure in the New Landscape of Risk

With the advent of high-frequency trading, measuring microstructure risk has not only become easier due to the availability of data, it has also become mandatory. Over the past several years, so-called flash crashes have triggered stop losses and caused numerous investors to liquidate positions early or forced investors out on the sidelines of the market altogether. Aggressive high-frequency traders have been shown to worsen market conditions and instilled dread, anger and a feeling of hopelessness in many market participants. Runaway algorithms sank ships like Knight Capital Group, dealing multi-million dollar losses in a matter of minutes. While the academics have worked on the questions of microstructure risks for years, the practical applications of such research was not evident. Until now.

Enter the measured microstructure risk, a component of traditional idiosyncratic α. Highly persistent in individual securities, the microstructure risk cannot only be measured, it can be used in many daily applications, such as:
• Buy and hold equity selection
• Portfolio risk evaluation and management
• Collateral pricing
• Derivatives analysis
• Many more

Our firm, Able Alpha Trading, has specialized in intraday microstructure risk since 2007 and honed its expertise through numerous successful products, consulting engagements, academic papers and even a few books. Today, our most popular offerings include:
• Flash crash index, an advanced research-based tool that measures the propensity of individual securities to flash crashes at least one day in advance
• Percentage of aggressive high frequency traders present in the given security
• Abnormal trading activity index, capable of pinpointing runaway algorithms and other potentially fatal microstructure events in real time.

While there is significant intraday variation in the Flash Crash index and the Percent of Aggressive HFTs index, the averages of the indexes are persistent for individual securities and predictive at least one day in advance. As a result, successful deployment of indexes requires no advanced infrastructure on behalf of the client. These indexes can be accessed via our dedicated web portal and incorporated into the clients' respective modeling systems, even Excel spreadsheets.

Consider the following example. How would a long-only portfolio manager deploy the risk of aggressive HFTs in his work? Since the presence of aggressive HFTs is a persistent metric, it is a clear measure of the source of risk. In today's competitive investment world with often razor-thin margins, the risk induced by aggressive HFTs is a measurable variable that portfolio managers simply can no longer afford to ignore. Including the risk in one's calculations improves portfolio selection outcomes, delivering higher returns and lower risks for portfolio manager's clients.

Since microstructure risk can be successfully priced, making its measurement a necessity not only in buy-and-hold applications, but also in cases of collateral pricing in lending and derivatives structuring. At present, most models of collateral valuation do not, but should, account for the changes in the microstructure of the underlying. Since the value of debt can be expressed as the price of a derivative on the value of collateral, the risk of the collateral needs to include its microstructure effects to make the risk profile comprehensive. Understanding the microstructure risk involved in pricing of collateral provides a better ability to price loans, bonds and CDS.

Same goes for portfolio construction: to diversify the risks of one's total portfolio, consideration of alpha and beta alone is enough. It is the portfolio managers' obligation to consider the microstructure risk, to immunize the client portfolios from short-term risk and to compensate the client for bearing such risk to the largest extent possible.

Understanding microstructure risk is no longer an academic exercise it was some 20 years ago. It is now a mandatory requirement for all financial markets participants.