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November 1, 2012

'Kill Switch' Design Worries Brokers

By Peter Chapman

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  • 'Kill Switch' Design Worries Brokers

Brokerage executives are anxious about mechanisms designed by stock exchanges that will automatically shut off a firm's incoming orders.

Although the exchanges are considering a "layered" approach, whereby a brokerage receives alerts before a complete shutoff, the Securities and Exchange Commission appears to favor a more abrupt solution. And while the brokerage houses themselves will be permitted to determine the appropriate cutoff levels, execs worry they will be set too liberally to do any good.

"We worry about automation kicking in at the wrong time and perhaps destabilizing the system," TD Ameritrade chief technology officer Lou Steinberg warned participants at a roundtable sponsored by the SEC last month.

The so-called "kill switches" were proposed by an industry working group in September in reaction to the mayhem of Aug. 1, when systems operated by Knight Capital Group flooded the New York Stock Exchange with thousands of money-losing orders.

The SEC, concerned about the integrity of the marketplace, is pushing the exchanges to make sure such an event doesn't happen again. The regulator wants the exchanges to install simple and speedy trip wires that automatically cut brokers off.

At the roundtable, the SEC did not appear to want too much wiggle room built into the setup. Chairman Mary Schapiro expressed concern that alerting a brokerage before cutting it off may defeat the purpose.

"Is there time for that?" Schapiro asked about alerts. "It doesn't take very long in these markets-a couple of minutes-for an enormous amount of damage to be done."

The brokers, on the other hand, want to be alerted before they are cut off. For example, Steinberg wants a five- or 10-minute warning from an exchange before a cutoff. That way, he can explain whether the trading is normal or unusual.

"We believe a layered approach with a human discussion probably makes the most sense," Steinberg said at the roundtable.

The TD Ameritrade exec isn't the only brokerage official concerned about a hasty cutoff. Chad Cook, chief technology officer at Lime Brokerage, a firm that acts as a conduit to the public markets for trading firms, is worried about the "downside risks to the people we just cut off," he said during the roundtable. "How do we work around those things?" Cook suggested it might be necessary to build other technologies to "help offset some of the downside issues" involved with a kill switch.

Vaishali Javeri, an attorney with Credit Suisse, also fretted about getting cut off without warning. Speaking at the annual market structure conference sponsored by the Securities Industry and Financial Markets Association last month, Javeri was apprehensive about the "consequences of a shutoff" and the effect on clients. She wondered whether a "multi-layered kill switch that takes more time to implement" might be a better approach. "The details must be thought out," Javeri said at the conference. "It's not as easy as we might believe based on the reports in the media."

The "layered" approach to the kill switch is getting the endorsement of both brokerage and exchange officials, if not the SEC. It means that any attempt to cut a broker off could involve multiple warnings first-telephonic, electronic or both.