What is the Difference Between Brokering and Hedging in Compass?
While brokering and hedging share some similarities in Compass, they are distinct in how they are implemented and executed.
There are two primary differences between brokering and hedging.
- Brokering in compass is risk-free. Trades will not be filled until brokering is confirmed from the LP. If the LP rejects the trade, we can choose to internalise or cancel. Hedging on the other hand is only active once a trade has been confirmed and internalised. If an LP rejects the trade, the book will have risk exposure until a valid hedge trade can be made. Hedging can be configured to increase or decrease risk, depending on preferred levels of VaR, holding time, etc..
- We can choose which trades to broker, and which LP(s) to broker them to, while hedging is done by overall VaR of books - i.e. we do not choose to hedge individual trades or trades from a specific counterparty. Instead, incoming trades are designated into books, which are then broken down into assets and hedged based on equivalent positions.
Brokering
Brokering is risk-free, and can be executed by counterparty and instrument.
When we receive flow, we can decide, via execution rules, whether to take the other side of the trade and internalise the flow, or pass it on to an LP and broker the flow. When we broker flow, we first receive confirmation to broker from the LP before filling the trade. This means there is no risk on our side. Instead, we will take profit through mark-up.
We can use criteria such as instrument, counterparty, timezone, dynamic counterparty, etc. to decide on our execution style. Hence, when we choose to broker trades from certain counterparties, instruments, etc., we are doing so based on the information we receive from the FIX connection. This is in contrast to hedging, where the trade is first booked and split into its constituent assets, which are then analysed for hedging.
Hedging
While the hedgers can be configured to start hedging when we receive trades containing specific counterparties or instruments, hedging is done by book, not by trade - i.e. specific trades cannot be hedged against, but rather, the equivalent positions in the books will be hedged against. There is no one-to-one mapping of inflow to outflow.
Hedging is a separate process to execution. When flow is received, the execution process makes a decision on how it will be executed. Once an internalisation decision has been made, Compass uses configured risk control profiles to decide which book the flow should be booked against.
These books are then used to inform hedging; the hybrid and arb hedgers will look at the VaR in each book and make hedging decisions based on this. The exact implementation can be tuned in the hedger config in Compass.
Information such as counterparty and instrument pair are not taken into consideration by the hedgers. Rather, our positions in each asset (EUR, JPY, NOK, etc.) contribute to the VaR of a book, which upon hitting a configured level, indicate to the hedgers to begin attempts to offload risk. The hedgers will then look to make trades that reduce our equivalent position, therefore reducing our risk.