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January 3, 2011

SEC Seeks to Tame Algos Gone Wild

By Peter Chapman

The Securities and Exchange Commission is considering rules covering the use of algorithms. In the wake of the SEC's May 6 "flash crash" report, which implicated a solitary algorithmic trade as the catalyst for the event, the regulator is talking about requiring brokers to take more responsibility for their algorithms.

Greg Tusar

"We're thinking about whether there should be some risk controls on algorithms," said David Shillman, an associate director in the SEC's Division of Trading and Markets, at the Investment Company Institute's annual equity markets conference last month. "That may involve a question or an override if the algorithm is operating too aggressively."

In its report on the events of May 6, the SEC identified a series of algorithmic trades in the futures market done by a single mutual fund, now known to be Waddell & Reed, as the trigger for the cascade of sell orders that briefly slammed the equities market.

In considering rules for algo usage, the SEC is attempting to address "situations where the algorithms are so aggressive that the result may not be what is intended by the user and could have a destructive effect on the market," Shillman said.

The SEC wants brokers to "double-check" before sending out an algorithmic order and perhaps throttle back if the algorithm is stressing the market, he noted.

The official's comments follow similar probing by the Commodity Futures Trading Commission. The CFTC, which regulates the futures market, is seeking comment as to whether brokers should be held liable for market disruptions due to trades done on behalf of their customers.

Shillman noted that there may be a section in the Securities Exchange Act of 1934 that permits the SEC to place obligations on brokers, giving them a duty to the market. Right now brokers only have a duty to their customers to get "best execution."

The SEC is not seeking to "heavily regulate" the use of algorithms, Shillman said. Nor is it interested in regulating the buyside's level of aggressiveness when using algorithms. The commission only wants brokers to think twice before sending out an algorithm that might threaten the stability of the market.

At least one big broker agrees with the SEC that more must be done to contain any damage to the market from the use of algorithms. Greg Tusar, a managing director in the equities division of Goldman Sachs, told the ICI crowd that brokers need to engage their clients in an ongoing dialogue about the impact of their order-handling practices, especially in "abnormal circumstances."

"What happens if I move the stock by 3 percent," Tusar asked rhetorically. "What about 5 percent? What sorts of limits should be in place? How should the algorithm behave? We need to reinvigorate that dialogue."

Tusar noted that such conversations, once at the center of the relationship between the sales trader and the buyside trader, are occurring less often in the era of algorithms. "That dialogue needs to increase a lot from where it is today," he said.


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