Nasdaq Buttressing Options 'Kill Switch' to Deal with Runaway Algos
Traders Magazine Online News, October 25, 2012
Nasdaq OMX Group is in the process of expanding the functionality of the 'kill switch' technology used by its options exchanges to deal with runaway algorithms.
Called 'Rapid Fire,' the technology is currently used to monitor the trading activity of the market makers on Nasdaq's three options exchanges and temporarily purge their quotes if the dealers are getting more fills than they want. The safety valve makes it possible for dealers to quote aggressively in thousands of options classes without fear of incurring too much exposure, too quickly.
Currently, the technology only monitors trading in individual options. But, with concerns increasing over algorithms that can go wild, Nasdaq is looking to extend the functionality of Rapid Fire to cover multiple options.
"If they get rapid-fired in "X" number of symbols in "X" amount of time, we will remove their quotes in everything in which they are assigned to," Tom Wittman, Nasdaq's head of U.S. options, told Traders Magazine. "That's because there is likely some sort of problem, whether it's their system or our systems or some algo running wild."
In other words, if it looked like a market maker was in trouble because his pricing model or a counterparty's liquidity-removing algorithm had gone awry, Nasdaq would shut down the market maker completely.
Under the plan, the firm could only re-enter the market after a human being at the trading house contacted a human being at the exchange. Currently, the exchange is trying to come up with some metric or metrics that indicate a market maker might be in trouble.
A shutout could be triggered, for instance, if the market maker is getting hit on a certain number of symbols during a given time frame. Or it could be a volume-based indicator that would trigger if the trading house was doing more volume than usual in a certain time frame, Wittman explained.
"So we are looking to expand it to make it a little more comprehensive," Wittman said. "We'll add more protections which will then force a human intervention process." Nasdaq is involved in discussions with its 35 market makers over what indicators to use.
The discussions come during a tumultuous year for both the cash equities and the options markets as algorithms have run amuck in both camps. In February, Ronin Capital spewed 30,000 mispriced quotes into NYSE MKT Options, resulting in significant losses for the options market maker. In August, Knight Capital Group lost control of its own algorithms, racking up hundreds of millions of dollars in losses in less than an hour of trading at the New York Stock Exchange.
As a result of the Knight fiasco, traders in cash equities are now 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.
Nasdaq's Rapid Fire was developed eight or nine years ago by the Philadelphia Stock Exchange, which Nasdaq bought four years ago. Wittman, responsible for all three of Nasdaq's options exchanges, was part of the team at the Philly that developed Rapid Fire.
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