Concentrated Positions and Market Risk

Sometimes the financial institutions may hold financial positions that are very large in size relative to the traded volume in a market for those securities. Whether these positions are long or short, when the bank decides to liquidate these positions, it may significantly affect the price of the securities and may disrupt the market. In such a scenario any market participant who wants to exit the position may suffer greater-than-expected losses. Due to this, the market makers should monitor the extent to which the positions they take constitute a large portion of open interest, volume, or some other indicator of market size.

Different products may have different market liquidity characteristics for many reasons, such as contracts that have different maturities or expirations, that are traded on different exchanges, or that represent even slightly different underlying. Such products need to be monitored separately and not as a group.

It is also suggested that the market makers:

  1. Monitor the concentration of positions of counterparties relative to the market and
  2. Recognize that counterparties that take on large positions relative to the market volume are taking on greater price risk and may have difficulty unwinding their positions without substantial losses.