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November 1, 2012

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Exchanges Move to Fine-Tune On/Off Switches for Quotes

By Peter Chapman

Traders in cash equities may be grappling with the newfangled concept of kill switches. But for traders working in listed options, they're old hat.

Known variously as "risk monitor" or "risk limitation" mechanisms, these exchange-operated devices have been protecting options market makers from losses for eight or nine years.

Now, after a spate of algo blowups, there are moves afoot to tighten existing mechanisms and introduce new ones. (In options, the notable case was the Ronin Capital glitch in February, when the market maker disrupted trading at NYSE Amex with more than 30,000 wildly mispriced quotes.)

NYSE Euronext, for instance, recently introduced changes to its kill switch that are expected to help market makers avoid unnecessary quote kick-outs and produce more purges when they're actually needed.

Nasdaq OMX Group executives are making plans to widen the scope of the exchange operator's Rapid Fire risk-protection system in ways that could lead to wholesale shutdowns of dealer quotes.

Systems such as Rapid Fire are relatively simple mechanisms for managing risk. They temporarily purge a market maker's quotes in a given option from the montage if they are getting traded against more than the dealer likes.

The market maker itself sets thresholds for removing quotes, based on its tolerance for risk. After a purge, the market maker typically re-enters the market in less than a second with updated quotes.

Although options market makers are required to quote two-sided markets in most of their options for a good portion of the day, they only expect to enter into a certain number of trades within a given time frame, or to trade a certain number of contracts within a given time frame.

When the market moves in an unexpected way and they wind up doing more trades or contracts than expected, dealers want to temporarily exit the market to reprice their merchandise.

To make sure they get out in time, they partly rely on exchange systems like Rapid Fire to monitor their trading activity and shut them down when their trading reaches preset levels.

Unfortunately, the technology at the NYSE was of no help to Ronin in February, when the market maker flooded the NYSE Amex exchange with the mispriced quotes. The parameters were set too generously, and bad trades left the dealer facing a loss of somewhere between $500,000 and $2 million, according to options traders.

Despite the occasional glitch, market makers are generally happy with existing kill switches on options quotes. "There's very little downside when those switches go off, and they do go off a lot," said Jerry O'Connell, the chief compliance officer with options market maker Susquehanna International Group, at a recent industry conference. "It allows the firm to provide as much liquidity as they feel they possibly can."

Given the current focus on creating kill switches in cash equities (see article on Page 18) following the Aug. 1 flood of erroneous orders from market maker Knight Capital, Traders Magazine decided to check in with a couple of the options exchanges to see what new approaches to on/off switches might be in the works.

Tom Wittman runs the options exchanges at Nasdaq, which include Nasdaq OMX Phlx, Nasdaq Options Market and Nasdaq Bx Options. Steve Crutchfield runs the exchanges at NYSE Euronext, which includes NYSE Arca and NYSE Amex.



NYSE: Retooling