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Wednesday, July 21, 2010

Defending Against the Algo Pirates

Posted by John Bates

It was an honor to sit on the CFTC Technology Advisory Committee (TAC) last week. I was very impressed with the presentations and discussion, chaired ably by Commissioner Scott O’Malia. I was also impressed by the other Commissioners and with my fellow committee members. This week the CFTC has been discussing new rules to handle disaster recovery and has also received further coverage on one topic discussed at the TAC – that of pirate algos attacking algos going about their normal trading business and aiming to manipulate the market.

 

Further coverage can be seen in this article “CFTC posits new disaster recovery rules as regulators probe 'algo price pirates'”

 

http://www.finextra.com/news/fullstory.aspx?newsitemid=21610

 

The CFTC has a sensible proposal on the table to require exchanges and clearing houses to have effective disaster recovery plans in order to quickly recover from any market-wide disruption. After 9/11 it became clear that many NYC-based financial services firms were not prepared for a disaster of that magnitude, and subsequently took disaster recovery (or business continuity as it came to be known) very seriously. Now it is time for those virtual businesses - exchanges and ECNs - to do the same.

 

Operational risk is a very real issue in today's fast moving markets, where anything can go wrong. Being able to recover and quickly start trading again - across all exchanges and destinations - is paramount. The May 6th 'flash crash' gave us a glimpse of what can happen if something went wrong at one exchange and the rules across other exchanges were not harmonious.

 

The flash crash was a man-made event exacerbated by machines. Algorithms are programmed to do as they are told, and if one destination is not responding they will hunt down and ping, scrape and trade on whatever others they can find. Sometimes this can have unfortunate consequences for the market as a whole. This is why there must be consistency across trading venues in how they respond to crises.

 

At the CFTC's Technology Advisory Committee meeting last week, there were several interesting observations about high frequency trading and algos. We heard new analysis of the flash crash from trade database developer Nanex LLC. The Nanex report suggested that predatory practices such as "quote stuffing", where algos try to prevent others high-frequency traders from executing their strategies, may have contributed to the crash. Commissioner Chilton of the CFTC (who I had the pleasure of sitting next to at the TAC last week), the TAC and the SEC are taking these claims very seriously. Commissioner Chilton expressed his concern that there are algorithms out there hunting down and interfering with other algorithms, calling them 'algo price pirates' that may trigger a new enforcement regime. Now I believe that firms and their algos are going to be monitoring the market with the goal of figuring out how your algos work and devising a strategy to capitalize – that’s just the natural order of capitalism. However, that’s different from using algo terrorism to bully the market into behaving a particular way. That’s something we need to watch for and prevent for it causes damage.

 

If such 'pirates' are to be policed and caught, the regulators will have to sail with the pirates in shark-infested high frequency waters. Surveillance and monitoring are critical, as is the need for speed. The speed at which algorithms can pump quotes into a destination is daunting, so the policemen will also need to work at ultra high velocity. I was a little concerned when Commissioner Chilton said at the TAC meeting: "Just because you can go fast it doesn't mean you should." I know where he’s coming from but would modify the statement to say that in HFT it is critical to go fast to be competitive – but you need the proper best practices, training and safety precautions. High frequency trading, if properly monitored, need not be scary or evil. It can contribute to liquidity and market efficiency, and provide alpha generation. To truly address the HFT issue, real time market surveillance technology must be adopted to monitor and detect patterns that indicate potential market abuse such as insider trading or market manipulation. Or pirate algorithms trying to board your strategy ship and take off with the gold doubloons. 

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