With the run of technology snafus this year, Traders Magazine decided to take a look-see at the problem. We present the story in two parts. Part 1 is posted today. Part 2 will be posted tomorrow.
Is trading out of control?
Given the spate of high profile blow-ups this year, industry professionals and the regulators are starting to wonder. All the snafus were caused by software glitches, which leads trading experts to question whether brokers and exchanges know what they’re doing when building complex automated systems.
First came the Ronin Capital debacle on Feb. 24, when the options market maker disrupted trading at NYSE Amex with more than 30,000 wildly mispriced quotes. Then came the failed public offering of BATS Global Markets by BATS itself on March 23. That was followed by the botched public offering of Facebook by Nasdaq OMX Group on May 18, resulting in millions of dollars in losses for market makers. Finally, on Aug. 1, Knight Capital Group lost $440 million due to a software malfunction that flooded the New York Stock Exchange with a series of bad orders.
Taken together, the perception is the industry is losing control. “The complexity of some systems overcomes the best efforts of designers to keep them under control,” says Harish Devarajan, chief executive of Deep Value, a developer of trading algorithms used at the New York Stock Exchange and elsewhere. “All systems start off as things that do our bidding. But some rise in complexity to the point where we masters become the servants of the system.”
New Rules
A week after the Knight debacle, the Securities and Exchange Commission announced it would convene a roundtable of trading technologists in Washington on Sept. 14 (postponed to Oct. 2) in an effort to determine if brokers and exchanges are in control of their trading systems. The SEC has billed the session as an information-gathering workshop, but Chairman Mary Schapiro has also stated that her agency intends to roll out new rules, as well.
At a minimum, the SEC is targeting the exchanges and other market centers with a rule requiring them to make sure their systems function properly. The regulator has had a so-called “Automation Review Policy” for more than 20 years that requires exchanges to make sure their systems are working properly and to report any outages that occur. This is a statement of policy, however, and not a set of rules. Schapiro said last year ARP should become mandatory.
In the wake of the Knight crisis, at least one influential lobbying group is pushing the SEC to adopt new rules. The Managed Funds Association, which represents hedge funds, sent a letter to the regulator recommending several rule ideas. Chief among them were mandatory risk checks of all a broker’s orders; new rules requiring systems testing; and the requirement that firms designate an individual to stand watch over the broker’s trading systems armed with a “kill switch.”
Whether or not regulators heap new rules on the industry, they are certainly not shy about using existing ones to punish firms for writing bad code. Last October, for example, the SEC reprimanded exchange operator Direct Edge for deploying untested code that resulted in $2 million in losses for the company. A month after that, CME Group, which regulates trading on its futures exchanges, fined market maker Infinium Capital Management $850,000 for failing to prevent its trading algorithms from going berserk in the E-minis and oil futures markets.
In penalizing Infinium, CME took into consideration that the trading house did take steps to clean up its act. After its algos got it into trouble in 2009, Infinium adopted some of the recommendations of the Futures Industry Association’s Principal Traders Group (PTG) regarding quality assurance controls and risk protections, according to CME Group.
PTG recommendations have become de facto standards for some firms. Over the past few years, the PTG has written a number of reports offering specific guidance to electronic trading firms regarding risk management and best practices. Earlier this year, the organization published a number of specific tests and controls that trading firms should consider whenever they make changes to their systems.
Headlands Technologies, a quantitative trading firm based in San Franciso and Chicago, is one firm that has adopted the guidelines. “We’re not going to eliminate mistakes,” Matt Andresen, co-chief executive of Headlands said. “But we can try to minimize them by insuring best practices. That means mandating procedures and policies for how someone interacts with the marketplace.”
While calls for best practices might be expected in the current climate, it is the issue of accountability or responsibility that generates the most debate. Who or what should be responsible if trading programs run amuck? If a broker algo disrupts the market, is it the broker’s responsibility to shut it down or that of the venue?
On Aug. 1, Knight’s algos-gone-wild traded about $7 billion in notional value during the first 40 minutes of the day, driving volume in such names as Molycorp and Lithia Motors to unprecedented levels. All and all, the NYSE was investigating trades in about 140 stocks, opting to bust those in six. The big market maker mistakenly bought at the offer and sold at the bid, losing the spread on every trade. Despite the havoc, the NYSE chose not to cut Knight off.
NYSE declined to comment. But other sources noted that exchanges are typically reluctant to unilaterally prevent trades from occurring. That’s because the trades may not be erroneous, so blocking them might open the exchange up to liability.
In any event, it was the second time this year an exchange run by NYSE Euronext decided not to intervene when an algo went wild in its market. In February, options market maker Ronin mistakenly transmitted over 30,000 mispriced quotes to NYSE Amex Options. The quotes were traded against and the firm reportedly lost somewhere between $500,000 and a few million dollars, according to sources.
Amex does offer market makers risk management tools to protect themselves against unwanted executions, but usage is voluntary. Amex does not take unilateral action to shut off a market maker, despite any concerns it might have. It does not second guess a dealer.
Unless instructed otherwise, the exchange assumes any quotes it receives from dealers are appropriate. “Market makers can send us quotes at any price they desire,” Steve Crutchfield, Amex chief executive, said at a press briefing in May, “and we don’t reject them. I mean, who are we to say the price is wrong?”
Sea Change
Still, the executive is uncomfortable with that policy. In April, Crutchfield called on other options exchanges to work together with the SEC to produce a policy that would allow exchanges to reject orders or quotes they deemed harmful to the marketplace. “It would be a sea change,” Crutchfield colleague Amy Farnstrom, co-CEO of NYSE Arca Options, told reporters.
At least one brokerage executive believes such steps are necessary. Jim Michuda, chief executive of Wolverine Execution Services, notes that exchanges offer risk mitigation tools to their members, but some cost money and usage is optional. Michuda argues that exchanges should unilaterally be willing to cut a participant off if the firm’s trading appears out of control.
Michuda says exchanges should closely monitor the size and frequency of members’ orders and compare that data against the volume characteristics of the security. If it observes a participant trading relatively heavy volume in a short period of time it should take action. “The exchanges should have reasonable limits in place,” Michuda said. “They need to have safeguards to stop or slowdown some of this stuff. The last stop is the exchange. They are the last arbiter of sanity.”
And what about inside the errant organization? Who should be on the hook if an algo goes wild? Software developers build the algorithms, but traders or those on the business side use them. If they malfunction, who should be held accountable?
After Nasdaq’s Facebook snafu, the blame was being placed on the technology side of the company, according to Wall Street Journal reports. At a conference at Stanford University, Nasdaq chief executive Bob Greifeld told attendees the business side relied too much on assurances from the technology side. The Journal also reported Nasdaq was considering a restructuring of its technology and operations departments, possibly firing Anna Ewing, Nasdaq executive vice president in charge of technology.
At least one veteran trading technologist argues the blame should fall on the business side, not the technology division. The idea of firing Anna Ewing is “ridiculous,” he said, adding that top brass on the business side should be accountable. “There is a trader who is responsible for those trading systems. Somebody has to take responsibility and it’s not the programmer.”
The SEC may have other ideas. In December 2010, at a conference sponsored by the Investment Company Institute, David Shillman, an associate director in the agency’s Division of Trading and Markets, told reporters the SEC was mulling the idea of imposing “baseline qualifications” on algo developers and users. The idea was to prevent unqualified individuals from designing algorithms.
That idea has appeal for one executive on the business side of algo trading. In the pages of this magazine, Dan Mathisson, who runs Credit Suisse’s U.S. equity trading department, came out on favor of such a move. “I suggest it’s time for a new license, “Registered Algorithm Developer,” for people who are directly involved in coding or supervising algorithmic trading code, who do not already have a Series 7 license,” Mathisson wrote in January 2011.
To be continued…
