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December 21, 2010

Why Standards for Algorithm Developers Are a Good Idea

 I have a friend who is a licensed beekeeper. He had to take a written test administered by the state, presumably to ensure he would not do anything dangerous, like persuading local allergic children to copy that "bee beard" guy in the Guinness Book of World Records. A surprising number of jobs require licenses-in New York, you can't cut hair without a barber's license, cut wires without an electrician's license or cut a deal on a house without a real estate broker's license. The New York Times reports that licenses nationally are at a record high, with 31.6 percent of full-time workers requiring a federal, state or local license. James Bond is licensed to kill, Jimmy Buffett is licensed to chill, and the Beastie Boys are licensed to ill. And now add algorithmic trading developers to the list, who may soon become licensed to fill.

We recently learned that the Securities and Exchange Commission is "considering standards for the professionals who program the [algorithmic trading] codes," according to the Financial Times. At the Investment Company Institute's December conference, David Shillman, a senior policy maker at the SEC, said that the SEC was considering several new controls for electronic trading desks-everything from licensing developers, to establishing consistent roll-out procedures, to adding "some sort of throttle if an algo is behaving too aggressively."

The algorithm developers who work for me were not thrilled to read about this. They immediately began dreading having to study for the Series 666, then being forced to add Big Brother's throttle to their elegant code, and then having to spend the rest of their professional lives filling out form PW-6(b) in triplicate before being allowed to release a new version of VWAP. But at the risk of a worker revolt, I have to admit that Shillman has a good idea. In the wake of the "flash crash," which was partially blamed on the unfortunate coupling of a very large futures order with an algorithm that had insufficient brakes, the industry needs to acknowledge a basic truth: We are all better off with clear rules and standards that prevent market disruptions and career-ending errors.

Six weeks after the flash crash, the regulators rolled out the pilot for the first of the new controls-the successful single-stock circuit breakers, which briefly halt trading when a stock drops 10 percent within five minutes. Although the circuit breakers have made a repeat of May 6 highly unlikely, a large order can still cause an ugly enough move  to send a trader or algo developer  on a long unplanned vacation. To prevent errors, responsible brokers have long incorporated careful testing and roll-out procedures, "fat-finger" checks and various computer bug checks into their algorithmic systems, catching and flagging both inbound and outbound orders that appear larger than what the market can safely absorb.

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