As a primer for today’s Securities and Exchange Commission Market Technology Roundtable, Traders Magazine presents three stories and topics that are sure to come up today. The topics range from so-called “kill switches,” exchange views on technology and the heady pace of rulemaking.
The first panel discussion of the day is slated for 10:15 am EST.
Exchanges Prepared to Set Up ‘Kill Switches’
NYSE Euronext, NASDAQ, BATS and Direct Edge say they are prepared to set up limits on the amount of trading their members conduct in a given trading session and shut them down if they exceed pre-set peaks.
The trigger mechanism was spelled out in a comment letter submitted Friday morning to the Securities and Exchange Commission.
The letter was submitted in advance of Tuesday’s SEC roundtable on market stability, called after waves of erroneous orders from market maker Knight Capital flooded national exchanges on August 1. The exchange-run controls would act as ‘kill switches’ on unusually high order or trade volume.
The controls are the prime proposal of a series of possible answers to “significant unintended market activity” suggested by a combination of exchanges, brokers, institutions and the Financial Industry Regulatory Authority that formed an industry working group after the disruption that nearly caused the demise of Knight Capital, one of the leading market makers on the New York Stock Exchange and other venues.
The working group includes Bank of America Merrill Lynch, Citadel, Citigroup Global Markets, Deutsche Bank Securities, GETCO, Goldman, Sachs & Co., IMC Chicago, ITG, Jane Street, Morgan Securities, RBC Capital Markets, RGM Advisors, Two Sigma Securities, UBS Securities, Virtu Financial and Wells Fargo Securities.
The letter is signed by NYSE Euronext, Nasdaq OMX, BATS Global Markets, Direct Edge, the Chicago Stock Exchange, FINRA and the Depository Trust & Clearing Corporation, the industry’s post-trade utility.
Triggering a potential shut down of abnormal activity would be a metric called “Peak Net Notional Exposure.’’
This calculation would place limits on the overall activity of a member firm and, “if the firm breaches its set limit, the SRO would shut down the trading session,’’ according to the letter submitted by the exchanges, FINRA and DTCC to the SEC Friday.
Here is how the ‘kill switch’ would work.
Exchanges would establish and maintain controls that track the “peak net notional exposure” of a market maker, brokerage, trading firm or other member firm, throughout a trading day.
Limits would be set for the total financial exposure taken on each day by a market participant. Long or short positions, or combination long and short positions, would each count against the total exposure taken on. Going long $600 on one stock and $400 short on another, for instance, would count as $1,000 “net” exposure.
The caps would be designed to spot excessive market activity, such as occurred on August 1. When a firm hit its limit, the exchanges would send out an alert. If the peak is exceeded, the exchange would shut down trading by the member firm.
The caps could be adjusted, so that they rose, or fell, in relation to the amount of overall trading volume occurring on a given day on a given exchange.
Faster ‘kill switches’ are needed to prevent market disruptions such as the August 1 flood of erroneous orders from market maker Knight Capital, the head of FINRA said last week at the Security Traders Association meeting in Washington, D.C.
”Kill switches have to be far more hair-triggered than they have been in the past,’’ chief executive Richard Ketchum said.
BATS: Pre-Testing Algos Makes Sense
On the eve of the convening of two industry roundtables on repeated technical errors in stock markets being convened by the Securities and Exchange Commission, BATS Global Markets told the federal regulator that “before a broker-dealer launches a new algorithm or a trading center introduces a new order type, the broker-dealer or trading center should ensure that there has been adequate user acceptance testing and experience with the new code or order type in a certification environment.”
The length of time for such testing should vary, based on the complexity of the new code or the order type, BATS said in a comment letter signed by general counsel Eric Swanson.
BATS, in its letter, noted that a fault in “a single line of code” caused its own matching engine to go into an infinite loop earlier this year, causing the initial offering of its own stock to fail on its own market and on its own technology.
BATS, in its letter, said “complex trading algorithms and order types should be subject to staged rollouts into live symbols where possible.” Staging rollouts, it said, would help identify problems “before they cause catastrophic impact.”
BATS also recommended using “test” symbols in production environments, rather than actual stock stymobls, to test new codes and order types, as another means of limiting or avoiding disruptions, before they occur.
BATS also said “monitoring can be built into automated systems to alert operations personnel at the first indication of an unresponsive, or “looping,” process” to ensure a timely response
The letter was submitted in advance of Tuesday’s SEC roundtable on market stability, called after waves of erroneous orders from market maker Knight Capital flooded national exchanges on August 1.
King of Retail: Slow Down Rule Making
A newly formed specialist in market structure issues on Monday recommended to the Securities and Exchange Commission that it slow down its approval of new rules and order types, in order to avoid unexpected market disruptions.
KOR Trading, an Omaha firm led by former TD Ameritrade executive Christopher Nagy, said highly publicized market events such as the BATS Global Markets failed IPO in March, the Facebook IPO that was delayed and whose orders were not smoothly carried out by the Nasdaq Stock Market and the Knight Capital flood of mistaken orders on August 1 all “can be traced back to coding and order-type changes” that were filed with the SEC and got immediate approval with little or no comment.”
The SEC on Tuesday is holding a Market Technology Roundtable to try and identify the cause of errors in the BATS, Facebook and Knight cases and find ways to preclude recurrences.
Besides the call for a slower, more considered rule-making process, at least four individuals and organizations on Friday and Monday called for the SEC to add Eric Hunsader to the panelists appearing before it Tuesday.
Hunsader and his firm, market data aggregator Nanex.net of Winnetka, Ill., have been at the forefront of statistically identifying the emergence and causes of market disruptions from the Flash Crash of May 6, 2010, to the Knight Capital flood of erroneous orders on August 1.
In the case of the failed BATS IPO of March 23, Nagy and KOR Trading said that the problem was traced back to a single he issue was traced back to a single line of faulty computer code, updated in anticipation of the IPO.
“While BATS did institute rule filings which required expedited processing for commission approval” under the Dodd-Frank Wall Street Reform Act of 2010, “BATS subsequently submitted a filing and (got) immediate effectiveness of a proposed rule change to modify” a rule on auctions of exchange-listed securities on February 10th, 2012, 26 business days before the launch of the failed IPO.
In the case of Nasdaq’s botched Facebook IPO, “Nasdaq submitted many filings prior to the Facebook IPO,’’ Nagy said.
In one, Nasdaq’s filed and got immediate effectiveness of a rule to adopt a modification in the process for initiating trading of a security for an initial public offering on March 19, 2012.
That “required coding changes with Nasdaq from brokers and dealers to a specific order type who route to Nasdaq. Neither of the rules described above, nor Nasdaq’s filing on Rule 4753 in January 27th 12 which was also filed as immediate effectiveness, received any comment. ‘
In the Knight Capital case, the cause can be traced “to coding changes required as a result of NYSE’s new order-type entitled, Retail Liquidity Program.’’
The commission, KOR and Nagy say, realized “the complex nature of the program and delayed approval two times (the maximum allowed) until its final approval on July 3rd, 2012.”
“While one would surmise that there was ample time for testing and coding changes, consider that the rule was adopted on July 3rd and NYSE implemented the program on August 1st, just 19 business days post approval,’’ KOR and Nagy said in a comment letter filed Monday with the SEC.
