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.
Back then, the exec explained, the problem for market makers was-and still is-getting hit in large amounts on one side of their quote in a short period of time.
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.
Rapid Fire keeps track of the percent of a dealer’s quoted size executed within a given time frame. If the dealer is hit on more contracts than desired within that time frame, the system will temporarily purge its quotes. Market makers can set the time to any one-second interval between 1 and 15 and any percentage of their size above 100.
Options market makers are generally happy with the exchanges’ kill switches. “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.”
Nasdaq operates three options exchanges, including Nasdaq OMX Phlx, Nasdaq Options Market and Nasdaq Bx Options.
