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December 1, 2004

The Dangers of an Algorithm Scandal

By Gregory Bresiger

Memo to regulators hunting for problems: Look for the math nerds.

That's the warning from an official of an electronic trading firm, who says the growing popularity of algorithmic trading is inevitably going to lead to some scandal.

"It is human nature that some scandal is going to happen with algorithms," warns J. Mark Enriquez, chairman of Pulse Trading, which operates an ECN aggregation service. He argues that regulators should be stepping up their efforts to monitor algorithmic trading. That's because there is a temptation that someone will use the mathematical formulas to improve proprietary trading.

"I've had customers of mine who have told me that they think that is already going on," Enriquez says. "For the time I'll give my fellow brokers the benefit of the doubt." However, he believes there are some who are using VWAP information to trade ahead.

Enriquez, whose comments came at a recent securities industry conference at Pace University, nevertheless stressed that there "are some legitimate areas for algorithmic trading use." He cited trading in liquid stocks, and basket trading in which there are many names, when one doesn't have many options.

Still, Enriquez's worst fears are shared by others. Celent Communications, an industry consultant, has drawn attention to the stock market collapse of 1987 and the Long Term Capital Market blow-up. "These two events suggest that model-driven trading, left unchecked, can cause short-term liquidity crises," according to Celent.