Futures

Thursday, July 19, 2012

Scooping FX Bubbles Out of a Boiling Pot

Posted by Ben Ernest-Jones

Foreign exchange trading appears to be moving from a beneath-the-radar, bank-dominated activity into the international trading limelight. There has been an explosion of new trading platforms and a wave of newer participants lately, partly thanks to new transparency afforded by Dodd-Frank and partly because of the relentless hunt for alpha. Increasingly automated, FX is also becoming the next go-to asset class for high frequency and algorithmic trading.

It wasn't always that way. As TABB Group's Larry Tabb said in an article in Wall Street & Technology: "FX has always been different. Be it that currency is a bank’s core product, be it that banks control the payments infrastructure, or be it that banks are critical in implementing Central Banks’ monetary policy, the banks have historically dominated FX."

Because FX is mainly traded via single dealer platforms, multi-dealer platforms such as FXall, and interdealer marketplaces, it is fragmented in a different way from equities.  Traditional trading platforms along with a couple of the sturdier newcomers like multi-dealer platforms FXall (which Thomson Reuters is buying) andCurrenex have been the dominant destinations for electronic trading of FX.

But now that the SEC and CFTC have clarified that forex contracts will be determined to be swaps, they will become part of the centrally cleared instrument pool. This means a whole new layer of banks, brokers, and venues are already popping their heads up. FX will soon emulate the expansion, consolidation, and then contraction of destinations experienced by the equities markets. 

There will be more opportunities for market participants to trade, hedge, arbitrage and manage risk. Algorithmic strategies will dominate, attracting more and more destination venues - and then fragmentation will be the mantra. So how are traders going to position themselves to scoop the profitable FX bubbles out? It is not as easy as you would think. In many cases, what appears to be an increase in liquidity is actually an increase in “phantom” orders, as institutions advertise the same underlying liquidity across an increasing number of locations. Trading algorithms will need to be smarter, and tuned over time to counteract this as the landscape changes.

Bank traders are looking for ways to handle the new world order of FX. Because their clients want to be able to trade forwards, swaps, spot and even options on the same system, banks are having to do the once-unthinkable: merge their forwards desks with their spot desks.

In the old days of voice trading, forwards and spot traders ran completely separate books and dealt with (mostly) different customers. Today clients are asking to hedge forwards and spot on the same system at the same time. Some want to trade using forward-to-spot conversions against aggregated spot prices from several platforms and some want to use aggregated forward rates directly. Some want a blending of both. The opportunities for banks are plentiful, if they can harmonize FX products, trading and hedging across trading systems successfully.

Many bank clients have seen what has happened in the equities markets; with high frequency trading and algorithmic strategies becoming problematic and largely vilified. When the world’s largest interdealer brokersaid recently that it would tackle “disruptive” practices by high-frequency traders on its foreign exchange platform it became clear that some of the lesser-loved equities issues were already creeping into FX markets.

The Wall Street Journal says that there are already fears of an FX "boom" reminiscent of the equities venue explosion in 2001. "Some market insiders fear the trend for highly specialized new systems aimed at separate pockets of clients could end up splitting the liquidity that underpins this $4 trillion-a-day market, making it harder to trade," said the paper. Pigeon-holing traders, whether it be by class of trader, asset class or by delivery date, only creates more fragmentation. This could equate to lower volumes (like equities), more volatility (like equities) and an increase in manipulative practices (like equities). Regulators will no doubt be watching, and new rules will be implemented even faster than has happened in equities.

In a discussion at the FX Week USA event in NYC recently one FX trading platform provider said that you need a full market ecology to provide proper efficiency. This means having all market participants operate in the same liquidity pool.  In the end the unique self-regulating properties of the FX markets mean that the market will shift towards what is best for the market - because it can. Preparation for this inevitability will determine who survives. 

Monday, July 02, 2012

Turning Metals into a Goldmine

Posted by Ben Ernest-Jones

"Every man now worships gold, all other reverence being done away," said Roman poet Sextus Propertius sometime around 15 BC.

Metals are hot. The Hong Kong Exchange's extravagant £1.39 billion bid to win the London Metal Exchange (LME) shows just how hot. HKE bought LME, which accounts for 80% of trade in nonferrous metals such as copper and aluminum, in a bidding frenzy against NYSE Euronext, CME and ICE.

From gold and silver to copper and nickel, it seems everyone is interested in buying and trading metals. Once the domain of producers and specialty traders such as Glencore and Marc Rich, investors globally are clamouring for access to this non-traditional asset class.

There is a natural cyclicality to asset classes; they wax and wane in popularity depending upon the opportunities to make money by trading them. Lately, investors have lost heart in stock markets and volumes are plummeting. Commodities such as oil and agriculturals lost their shine when demand in China and other emerging nations dwindled.

With returns shrinking in equities and fixed income market plays, it is no wonder that investors are interested in asset classes outside the traditional. Foreign exchange markets have been extremely active in recent years, for example, and with the current uncertainty over European debt problems demand for "safe haven" currencies is high. Precious metals often fall under that safe haven umbrella, which is presumably why interest has soared of late.

The correlation between gold and currencies such as the US dollar and the Japan yen is well documented, as gold and other metals are often used as a hedge against inflation or against a weak currency. There is also a strong correlation between gold and oil prices, and gold and the stock market historically. So there are plenty of opportunities to use metals for cross-asset-class trading, particularly in high frequency or black box strategies which monitor for anomalies in these correlations.

Luckily, pressure from investors is giving banks and brokers the incentive to break down the barriers to trading metals. Some brokers are adding metals to their foreign exchange trading platforms. We’re seeing an increase in the number of banks that are converting metals futures -  from CME, NYMEX, LME, etc. - into spot prices to stream to clients for trading. It looks like the beginning of a trend.

It is only a matter of time before banks and brokers are aggregating FX, metals, oil, stocks and bond markets for their clients - all onto one trading platform. Then we may finally see true cross-asset class and cross-geography trading. In the meantime metals trading may be the next goldmine for banks.

Wednesday, June 22, 2011

A foray into Beijing

Posted by Giles Nelson

Beijing was the last stop on my three city Asian tour and, from a personal perspective, the most exciting one as I’d never visited mainland China before.

China’s seemingly inexorable economic rise has been well documented. In the last 20 years, China’s GDP growth has averaged over 9%. As I travelled from the airport into Beijing’s central business district I saw few older buildings. Virtually everything, including the roads, looked as if it had been built in the last 10 years.

The Chinese stock market is big. In terms of the total number of dollars traded, the combined size of the two stock exchanges, Shanghai and Shenzhen, is approximately double that traded in the next biggest Asian market, Japan. The increase in stock trading has been very rapid. Trading volumes on Shanghai and Shenzhen have risen by approximately 20 fold in the past 5 years, although there has been significant volatility in this rise. 

The domestic algorithmic trading market is nascent. Currently, intra-day trading in company shares is not allowed. It is the recently established futures markets therefore where algorithmic and high-frequency trading are taking place. No figures exist on the proportion of trading done algorithmically in China currently, but I’m going to estimate it at 5%.

I was in Beijing to participate in the first capital markets event Progress has held there. Although Shanghai is the finance capital of China, we chose to hold the event in Beijing to follow up on previous work we'd done there. In the end, we had about 60 people along from domestic sell-side and buy-side firms attending which was a great result considering the relatively low profile Progress has at present in this market. There was optimism and an expectation that algorithmic trading had a bright future in China. 

I believe it's a practical certainty that the Chinese market will adopt algorithmic and high frequency trading. In every developed market a high, or very high, proportion of trading is done algorithmically and, although different regulations and dynamics make each market unique, nothing except an outright ban will prevent widespread adoption in every market in time. Liberalisation in China is occurring. For example, stock index futures are now traded, exchanges are supporting FIX, short-selling has been trialled and it is now easier for Chinese investors to access foreign markets. Also, earlier this year, the Brazilian exchange, BM&FBovespa, and the Shanghai exchange signed an agreement which may result in company cross listings. Only some of these changes support electronic trading growth directly but all are evidence that the liberalisation necessary to support such growth is happening. Inhibitors remain: no intra-day stock trading, restrictions on foreign firms trading on Chinese markets thus preventing competition and knowledge transfer from developed markets, and tight controls on trading in Renminbi. The Chinese regulators will continue to move cautiously. 

The question is not if, but when. We expect to sign our first Chinese customers soon. China is becoming a very important blip on the radar. 

 

Monday, May 02, 2011

Only You Can Prevent Flash Crashes

Posted by John Bates

Faster than a forest fire, the May 6th, 2010 flash crash was a breathtaking nearly-1000-point drop-then-surge on the Dow Jones Industrial Average that shocked traders and the general public to their core. Unlike Smokey the Bear, who can sniff out and fight fires before they start to flame, US regulators only became aware of the flash crash after it was over. The flash crash left scorch marks that have scarred the reputation of the bulwark U.S. stock market and singed investor confidence.

Regulators were completely stumped as to the cause. Months of investigations unearthed one very important piece of information: the regulators were unprepared and ill-equipped to deal with this kind of event. They had no method of sniffing out the smoke that could lead to a flash crash fire.

A year ago, the flash crash revealed the first significant sign of growing pains in a new generation of trading. This new generation introduced the capacity to let computer models do the dealing; it allowed clever traders with clever programmers to build complex algorithms that buy and sell in the blink of an eye. All of this progress was made with little thought to the possible repercussions of a mistake.

Thus it was that on May 6th, 2010 when a mutual fund in Kansas entered a rather large ($4.1bn) sell order in E-mini S&P 500 futures contracts on the CME, the reverberations were felt throughout the marketplace. The order sparked a totally human panic on a day when fear was in the air and sentiment was leaning toward the bearish. The fire was then fanned by algorithmic trading strategies and HFT, causing an unprecedented drop within minutes and wiping out $1 trillion in market value before recovering. That a simple mistake could take the market down so fast was unthinkable.

Since the original flash crash we have seen dozens of smaller ones, which barely warranted a thimbleful of ink in the press:

  • A mini flash crash nearly wiped out ten ETFs on Nasdaq OMX and NYSE Euronext on March 31st. The exchanges (quicker off the mark this time than on the May 6th flash crash) cancelled some of the trades in 10 out of 15 Focus Morningstar ETFs that had just been launched. Some of them tumbled by 98% before circuit breakers kicked in. The culprit appeared to have been a human being with fat fingers;  ETF market maker Knight Capital Americas took the blame.
  • Last September the CME Group plugged some new contracts into Globex to try them on for size and they mistakenly went live. They were almost instantly traded - for about six minutes. Futures brokers noticed oddly anomalous spread price activity during that period, when trading is usually slow, and CME pulled them off.
  • In the oil market last year high frequency trading firm Infinium Capital Management's brand new trading program malfunctioned and racked up a million-dollar loss in about a second, The new algorithm went live four minutes just before markets closed on Feb. 3rd and fired off 2000-3000 orders per second before being shut off. It caused a spike in trading volumes by nearly eight times in less than a minute and the oil price surged $1 then slid $5 over the course of the next two days.

And as energy and other asset classes outside equities - commodities, FX, derivatives - become increasingly automated there will be more flash crashes. Increased interdependence of asset classes will lead to cross asset flash crashes – a domino effect where the crashes 'splash' across asset classes, possibly wreaking havoc for market participants and regulators.  As regulators said following the flash crash: "a complex web of traders and trading strategies"  links the fragmented multitude of markets here in the U.S.    

Band-aids have been applied by the SEC; circuit breakers that prevent further trading when a stock moves more than 10% during a five-minute period. Market makers have been strong-armed to ensure they don't disappear when the market wobbles. The joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues has made 14  recommendations on the May 6 Flash Crash including: implementing a limit-up/limit-down system, more extensive market access rules, studying the impact of maker-taker pricing and cancellation rates, and looking at a more cost-efficient audit trail.

These are a good start, but far from address the underlying problem. Like Smokey the Bear, regulators need a way to sense the smoke before the fire takes hold of the marketplace. Luckily there exist responsive and intelligent algorithms that can sense and react instantaneously to market anomalies and anticipate interruptions to liquidity. These rapid response algorithms could help to prevent the next flash crash by alerting risk and compliance managers of impending issues, or by changing trading strategies to accommodate market glitches. They can smell the virtual smoke and help to put out the fire before it starts.

On top of smarter algos, there are a few other splash crash prevention measures:

  • Diligent backtesting – using historic data and realistic simulation to ensure many possible scenarios have been accounted for. A backtesting process needs to be streamlined of course – as short time to market of new algos is key. 
  • Real-time risk monitoring - building a real-time risk firewall into your algo environment. Just like a network firewall stops anomalous network packets reaching your computer, so a risk firewall should stop anomalous trades getting to trading venues. 
  • Real-time market surveillance. Even if trades do not breach risk parameters, they may breach compliance rules, regulations or may be perceived by a regulator as market manipulation.

Everyone needs to be proactive in using the correct tools to monitor algorithmic trading. Sensing and responding to market patterns before the aberrations or errors have a chance to move prices is the right thing to do - in all asset classes. Brokers need better pre-trade risk controls to prevent fat fingered trades from getting to market. Algorithmic trading means that the market moves too fast for exchanges or other venues to detect problems before they impact prices.  The detection of abusive patterns must happen in real-time, before any suspicious behaviour has a chance to move the market. This approach should be taken on board not just by the regulators, but by the industry as a whole. Only you can prevent flash crashes. 

 

Monday, February 07, 2011

The Trouble with Algorithms: Wild Children or Reckless Parents?

Posted by Dan Hubscher

Algorithms and high frequency trading have been blamed for everything from the credit crisis to the May 6th flash crash and high speed market abuse, and have attracted unwanted interest from regulators on both sides of the pond. But questions remain whether these tools are really computer models gone wild or whether they are the spoiled children of reckless parents - regulation.

According to Dictionary.com, the definition of reckless is to be utterly unconcerned about the consequences of an action. One could argue that the Regulation National Market System was designed without regard to some of the consequences down the line. Blaming the wild children, algorithms, is to ignore that the parents - RegNMS - were somewhat reckless in designing the system.

In a blog on the TABB Forum on January 24th,  Steve Wunsch of Wunsch Auction Associates explained that the system was working the way it had been designed.

"What really went wrong in the stock market on May 6? Prices aside, all of the plumbing was working fine. Not only were there no fat fingers, rogue algos, manipulators or terrorists at work, there were no significant breakdowns of order routing systems or data systems or any other elements of the stock trading infrastructure," wrote Wunsch.

Meanwhile, the National Commission on the Causes of the Financial and Economic Crisis in the United States released its report (Jan. 27th) and HFT was not mentioned at all. Nor were algorithms, as such, but 'computer models' were vindicated. The report said: "The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire."

And it criticized regulators for not doing their jobs: “Widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets.”

The result of the credit crisis and market meltdown in Sept. 2008 was the Dodd-Frank Act, which attempts to prevent another Sept. 2008.  But the flash crash insinuated itself into the picture, pointing out that no one had baked that possibility into the market reforms.  And, ironically, the market reforms set the stage for more flash crashes.

At the Tabb Forum Derivatives Reform Event a couple of weeks ago, a lot of people commented that Dodd-Frank puts in place a market structure that injects the equities and futures markets model, along with fragmentation, price transparency, streaming  quotes, into other asset classes. This theoretically invites algorithmic and high frequency trading and the threat of more flash crashes. At the event Peter Fisher of BlackRock said that what keeps him up at night is a flash crash in the interest rate market, citing the market structure argument, but specifically pointed out that this possibility was not envisioned in Dodd-Frank. 

With more and more asset classes becoming tradable electronically, partly thanks to mandated swap execution facilities (SEFs), the possibility of truly wild or rogue algos and market abuse becomes increasingly inevitable. And, as we pointed out last week, the very real possibility of a flash crash splashing across asset classes - we call it a "Splash Crash" - rears its ugly head.

Although the evidence against algos gone wild is thus far anecdotal for the most part, the belief that they can and will go wrong permeates the industry. Market abuse such as insider trading and manipulation are undoubtedly more prevalent. Fat finger errors are easier to prove, and are a fact of life in a high speed, high stress electronic marketplace.

Stay Calm and Remain Vigilant

The antonym of recklessness is vigilance. The regulatory parents must be more vigilant when it comes to their arguably brighter and naughtier children - algorithms and HFT. With algorithms and HFT come the possibility of mistakes and abuse. Many more firms outside of the equities world are embracing HFT and their inexperience can cause market disruptions. A flash crash in oil or other commodities - or even foreign exchange - is not to be scoffed at. In fact, many commodities markets are much less liquid and homogenous than equities, and can be even more vulnerable to mistakes or manipulation.

 There are a number of best practices that can be used to mitigate against algos going wild:

  • Diligent backtesting – using historic data and realistic simulation to ensure many possible scenarios have been accounted for. A backtesting process needs to be streamlined of course – as short time to market of new algos is key.  
  • Real-time risk monitoring - building a real-time “risk firewall” into your algo environment. Just like a network firewall stops anomalous network packets reaching your computer, so a risk firewall should stop anomalous trades getting to trading venues.
  • Real-time market surveillance. Even if trades do not breach risk parameters, they may breach compliance rules, regulations or may be perceived by a regulator as market manipulation.

An algorithm is a tool in a trader's toolkit, not a naughty wild child. If the regulator parents are vigilant, and algos are subject to practical controls and monitored constantly for performance and for errors, market participants can sense and respond to market patterns before the aberrations or errors have a chance to move prices.

-Dan

Tuesday, February 01, 2011

Beware the Splash Crash

Posted by John Bates

We have had the flash crash, the breathtaking 1000-point drop-then-surge that happened on May 6th, 2010. In the near future we will have a new worry - prepare for the “Splash Crash”, which will cross asset barriers in a single bound.

As asset classes outside equities - energy, commodities, FX, derivatives - become increasingly automated there will be more flash crashes. Increased interdependence of asset classes will lead to cross asset flash crashes – a domino effect where the crashes 'splash' across asset classes, possibly wreaking havoc for market participants and regulators.  

As regulators said following the flash crash: "a complex web of traders and trading strategies" links the fragmented multitude of markets here in the U.S.  And, like dominoes, when one goes the rest follow. The dominos are no longer limited to one asset class. Algorithms are becoming increasingly sophisticated, encompassing all of the elements that may impact a trade in a certain instrument. If a trader wants to take a substantial position in a foreign equity, for example, there are many ingredients that can affect its market price.

Consider news events such as the BP oil spill or the current political crises in Egypt and Tunisia. The impact of these events has illustrated the close relationship between the oil price, equities, foreign exchange, commodity futures and the bond markets. Extreme and possibly unexpected events coinciding can trigger a cascade. We saw with the flash crash how instability in European economies caused nervousness in the market and then an algorithm did something unexpected – causing a cascading effect across futures and equities markets. As the cross-dependencies grow and algorithms become more inter-twined, so the risks for a “splash crash” grow.

It’s not hard to consider a splash crash scenario given the growing inter-linking of markets. For oil companies, such as BP, equity trader’s positions can be affected by the price of the pound and UK interest rates, as well as the dollar and any countries currencies where it is exploring or supplying oil. Oil prices will impact the bottom line, therefore the share price. Political events such as wars in oil-producing countries are important, as are disruptive events such as oil spills, and can impact oil, equity, bond, commodity future and foreign exchange prices. What if China's economy falters and its oil consumption is predicted to fall? Oil prices globally fall, dragging the US dollar higher. Oil derivatives predicting that prices would stay high for the next year or two or three also fall. Share prices for the whole oil sector including BP, Exxon Mobil, Texaco, Chevron, Philips, Sinochem, etc. collapse. Debt markets are stunned and bond rates rally.

All of these factors can be programmed into an algorithm that monitors and makes trading decisions on the BP position. If large banks and hedge funds also have substantial positions in BP, the dollar, the debt and the derivatives and they also have algorithms that will kick in when certain parameters are met. If enough instability and unexpected conditions occur and then one of these algorithms does something strange or unexpected, the cascading impact could be enormous across all asset classes. For example, massive automated sell orders for oil shares, energy futures and derivatives and buy orders for USD and Treasuries. Trading systems could clog up, limited bandwidth could choke orders, exchanges could freeze up - splashing across all of the affected asset classes. Pandemonium.

Splash Crash Prevention Tips

Luckily there exist ever more responsive and intelligent algorithms that can react instantaneously to market anomalies and anticipate interruptions to liquidity. These rapid response algorithms could help to prevent the next flash crash by alerting risk managers of impending issues, or by changing trading strategies to accommodate market glitches.

On top of smarter algos, there are a few other splash crash prevention measures:

  • Use real-time pre-trade analytics and risk management. If the mutual fund in question on May 6th or its executing broker had done a thorough back-test of its trading strategy, using some of the dire indicators present, it might have thought twice about selling so aggressively - possibly preventing the crash.
  • "Light up" the algorithmic trading process. Visibility during the trading process is crucial. Surveillance technology exists than can monitor the markets for anomalous behaviour and alert the parties involved if it is spotted. Give the regulators the tools, too. 
  • Homogenize trading rules across all exchanges and ECNs. When one halts trading they all halt - for the same amount of time.

 

Thursday, November 04, 2010

A postcard to Jeremy Grant

Posted by Giles Nelson

Jeremy Grant, editor of FT Trading Room at the Financial Times, recently asked for explanations "on a postcard" about why speed is a force for good in financial markets, or put another way, to explain what the benefits are of high frequency trading. I've just come back from Mexico where I was addressing the Association of Mexican Brokers and during my visit I thought I'd write that postcard. So here it is:

 

Dear Jeremy

I saw your request for postcards recently, and as I'm travelling I thought I'd drop you one. There's not a lot I like doing more than explaining the benefits of so-called "high frequency trading".

I would suggest that you think of high frequency trading, or HFT, as being just the latest stage in the evolution of electronic trading. And this, as you know, has evolved very rapidly over the last decade because of cheaper and faster computers and networks. It's led to many innovations and benefits: electronic crossing networks, algorithmic trading, online retail trading, smaller order sizes, the overall increase in trading volume, more price transparency, greater trader productivity, more accessible liquidity, spreads between buy and sell prices tightening, broker commissions reducing, competition between exchanges and so smaller exchange fees - none of these things would have happened without electronic trading. MiFiD couldn't have happened; it simply wouldn't have been financially viable for the many alternative European equity-trading venues to launch without cheap access to networks and computers. Without these we would still have greedy, monopolistic exchanges with high transaction prices.

HFT is just the latest step in a technology driven evolution. You can't just look at it in isolation.

"Ah", you exclaim, "but high frequency trading is a step too far. Trades happening far faster than the blink of an eye. Surely that can't be right?"

So what if trades happen quickly? Things "going too fast" is a common concern. In 19th century Britain, people were worried about trains going faster than 30mph. They thought that passengers would suffocate or that as the train reached a corner it would simply come off the rails! And to those that say trading happens too quickly, at what speed should it occur? If not micro or milliseconds, should it be a second, a minute, an hour? Who's going to decide? Any choice is entirely arbitrary anyway; time is infinitely divisible.

There are plenty of things that happen too fast for humans to comprehend - human nerve impulses travel at more than 100m per second, yet we function successfully. Why? Because we have the monitoring systems in place that ensure the information from the nerves is processed correctly. Put a finger on a hot coal and it will be retracted immediately - quicker than we can consciously think. And if a 200mph train goes through a red light then warning bells will ring and the train will be automatically stopped.

And so to the main point. Trading speed, per se, is not the problem. But, yes, problems there are. Markets, particularly in Europe and the US are now very complex. These markets are fast moving, multi-exchange, with different, but closely interlinked asset classes. It is this complexity we find difficult to understand. Speed is only one facet of this. We imagine that an armageddon incident could occur because we know that the markets are not being monitored properly. Regulators freely admit this - Mary Schapiro recently said that the SEC was up to two decades behind in its use of technology to monitor markets. And because we know that the people in charge don't know what's going on, we get scared.

It doesn't have to be like this. The same technological advances that led to the evolution of HFT can be used to ensure that the markets work safely, by ensuring that limits are not exceeded, that an algorithm "going crazy" can't bring down an exchange, that a drunken trader can't move the oil price and that traders are dissuaded from intentionally trying to abuse the markets.

Doing things faster is a human instinct. Faster, higher, stronger. The jet engine, the TGV, the motorway. Would we really go back to a world without these?

Thursday, October 21, 2010

Breaking the Machines

Posted by John Bates

(This piece originally appeared on TabbForum - linked here)

 

The furore over high frequency trading and rogue algorithms is turning these important trading tools into fodder for the mainstream media. As part of the Commodity Futures Trading Commission's Technology Advisory Committee (TAC), I had high hopes that my colleagues and I would be an instrumental part of solving some of these issues that very publically dog our markets, including mechanisms for detecting or even preventing another flashcrash, stopping algorithms going out of control and curbing rogue traders. I believe the vanguard of such market improvements is not draconian restrictions on trading algorithms but rather regulator-led best practices and market policing. If the right measures are implemented and suitably publicized, it would address the market’s nervousness and have algorithms smelling fragrant once more.

 

I was thus a little disheartened by the second TAC meeting last week (Technology: Achieving the Statutory Goals and Regulatory Objectives of the Dodd-Frank Act). Given the public fear that algorithms and high frequency trading are evil, I was concerned when one commissioner even went so far as to ask the question in his opening remarks as to whether algorithms should be banned completely. If this ever did happen in the US, heaven help our economy. I would equate such an action to the Luddites – a group in 19th Century Britain that broke machines to protest against the industrial revolution. Algorithms are not evil; there are many positive aspects of algorithms and HFT. They minimize the market impact of large trades, lower the cost of execution, make more open and efficient markets, allow trading venues to evolve faster, encourage entrepreneurship and increase trader productivity, among many other things. Banning what is essentially the new industrial revolution, and now an integral part of electronic trading, could take us beyond a double dip recession and back into the dark ages.

 

A few key points came out in the flash crash report that really need to be emphasized. A key one is that there is a difference between algorithmic execution strategies and high frequency trading strategies. The former are manually set up and are designed to break up a large trade, typically executed in a broker on behalf of a buy-side customer. The latter are much more automated and continuously look for trading opportunities to act on, typically operated by a prop shop or hedge fund. The latter sounds scarier – but it was actually the former – or one particularly extreme instance of the former - that got the lion’s share of the blame in the joint SEC-CFTC report. HFT was pretty much exonerated. It was really human error in the way the execution algo that traded the E-mini was set up that was at fault. In fact one of the TAC participants actually made the point that many of the HFT algos had smarter monitoring built in – which made them pull back from the market when it started to go haywire. Yes that withdrew liquidity – but the HFT algos behaved sensibly given the circumstances.

 

Commissioner Scott O’Malia asked the question whether a rogue algorithm is the same as a rogue trader. Great question! An algorithm does not “decide” to go rogue, unlike a human rogue trader who is more deliberate. Usually a rogue algo is a mistake – such as Infinium’s algo that went wrong and fired thousands of orders into the market in February (http://www.reuters.com/article/idUSTRE67O2QQ20100825) or CME’s test algo that fired phantom orders into the market in September (http://www.ft.com/cms/s/0/706c45dc-c00a-11df-9628-00144feab49a.html). But rogue algos can threaten the well-being of a marketplace just as a rogue trader can. Rather than banning or restricting HFT and algos it would be much more productive to look at how they and the market can benefit from effective controls.

 

Some suggestions that I made on the TAC as to how we might provide more confidence around algo trading are as follows:

 

Firstly, market participants should be mandated to do better back-testing and algo monitoring to help prevent rogue algorithms and scoundrel traders from entering the market. Testing the execution algo that went wrong on May 6th under realistic market conditions might have prevented it going live. More intelligent monitoring might have made it pull out of the market before it did deep damage. Real-time monitoring can detect and respond immediately to dangerous market conditions, “fat finger” or algo errors and trading risk exposures being exceeded.  As illustrated by the HFT algos that stepped out of the market on May 6th – some firms have better monitoring technology than others! The CFTC and SEC could provide best practices guidance and maybe even recommend data sets, simulators and pre-production processes to help with this.

 

Secondly, Exchanges should continue to enhance their monitoring and surveillance systems. Clearly we’ve not perfected it yet given that a rogue algo within the CME managed to fire in phantom orders as recently as September. Also, to ensure consistent response to market crises, all trading venues in a particular asset class should have consistent circuit breakers, which operate under the same circumstances. This would avoid some of the problems discussed in the flash crash report.

 

And the CFTC (as well as the SEC) needs to be "mission control" to monitor across all markets and provide an early warning system. If firms believe they can be watched in real time they will be much more careful. Unfortunately, the CFTC’s Chairman suggests that there is no budget for such technology and that they will have to rely solely on controls by the exchanges and trading venues. This is unacceptable. The importance of trading to our economy means that ensuring confidence in our markets combined with allowing the world’s most advanced forms of algo trading - with the necessary safety measures to prevent meltdowns - is a matter of national security! The regulators are the US Marshalls to HFT's Wild West. The CFTC should go to Congress and make the case for a bigger budget. And they should strike while the iron is hot.

 

The flash crash may have been a mixed blessing, having pointed out many market structure issues that the regulators should be striving to correct or control. Until that day American stock markets were the envy of the world, the model for modern trading -- fast, stable, efficient and for the most part transparent (http://tinyurl.com/29bpr4r). That perception has changed and the rest of the world is aiming to avoid, not mimic, our model. It is critical that the US take the necessary steps to remain the shining example of capital markets. The technology is there, it simply needs to be used. Most importantly we must not allow negative publicity to lead us into Luddite-style regulation and break the machines that are fuelling this new industrial revolution.

 

Monday, October 11, 2010

When Does a Rogue Become a Scoundrel?

Posted by John Bates

Now that the Dodd-Frank Wall Street Reform Act is signed into law, there lies a mountain of work ahead for regulators. Making sense of the 2,000+ page document and turning it into viable recommendations and regulations will be an arduous process.

 

The Commodity Futures Trading Commission's second Technology Advisory Committee meeting titled “Technology: Achieving the Statutory Goals and Regulatory Objectives of the Dodd-Frank Act,” will be held on October 12, 2010 at 1:00 p.m., in Washington, D.C. (http://tinyurl.com/2vfdp4n). At the meeting, my committee colleagues and I will discuss some of these goals and objectives. Specifically, as a result of the SEC & CFTC's report on the May 6th flash crash, CFTC Commissioner Scott O'Malia has said that he wants to take a look at whether algorithms that cause disruption in markets - rogue algorithms - should be treated as if they were rogue traders.

 

Commissioner O’Malia said in the announcement of the October 12 meeting: “While I do not believe that the flash crash was the direct result of reckless misconduct in the futures market, I question what the CFTC could have done if the opposite were true. When does high frequency or algorithmic trading cross the line into being disruptive to our markets? And, along those same lines, who is responsible when technology goes awry? Do we treat rogue algorithms like rogue traders?"

 

This is an interesting topic. When does an algorithm 'go bad'? Is it the algorithm's fault? Of course not, an algorithm does not decide to go rogue. It is down to human error - either in the programming or the execution thereof. In the case of the flash crash a mutual fund chose a 'dumb' execution algorithm preset with inappropriate parameters to execute a large futures sell order in a market that was - by all accounts - ready to plummet. This circumstance illustrates how rogue algorithms can evolve as an unintended consequence of circumstance and/or human misjudgment.

 

When a trader goes rogue it is more deliberate. It can be because he is losing money and hiding it - as in the case of Jerome Kerviel at SocGen, or maybe he had too much to drink at lunchtime and was feeling invincible - like Steve Perkins at PVM. The former lost the bank over $6bn, the latter lost his brokerage $10m. These were very human errors, effectively the work of scoundrels.

 

What rogue traders and rogue algorithms have in common is that both can, in many circumstances, be detected early - or even prevented - through the use of better technology. Comprehensive pre-trade analysis, including backtesting algorithms under a wide range of circumstances, could have prevented the 'dumb' May 6th algo from having its way with the market. Thorough real-time risk management and monitoring could have spotted Kerviel's limit-busting trading patterns and his hiding the trades. Pre-trade risk controls would have kicked the PVM trader out of the system before he got in too deep.

 

It is no longer acceptable to blame rogues and scoundrels for market anomalies or for banks, brokers and buyside firms losing money. The technology is there, it simply needs to be used.

 

Tuesday, October 05, 2010

How One Very Naughty Algorithm Ruined Everyone's Day....

Posted by John Bates

The chaos theory says that small differences in initial conditions can yield widely diverging outcomes. Thus it was that on May 6th when a mutual fund in Kansas entered a rather large ($4.1bn) sell order in E-mini S&P 500 futures contracts on the CME, the reverberations were felt throughout the marketplace. The order sparked a totally human panic on a day when fear was in the air and sentiment was leaning toward the bearish. The fire was then fueled and fanned by algorithmic trading strategies and high frequency trading, causing an unprecedented drop within minutes.

 

As regulators said following the flash crash: "a complex web of traders and trading strategies" links the fragmented multitude of markets here in the U.S. And, like dominoes, when one goes the rest follow. That a large sell order for E-mini S&P 500 contracts on the CME, executed by an aggressive broker's algorithm, had such a devastating knock-on effect throughout the whole of the marketplace is telling. At first, high frequency trading programs absorbed the liquidity but, as prices dove, they changed their tack and began to sell as well. Liquidity was choked off. As traders tried to make sense of the situation, it because clear that the rest of the market was a-tumbling.

 

The futures contract - technically an ETF - is a stock market index futures contract based on the S&P 500. And the S&P 500 after all is made up of 500 individual equities shares. Panic, although a human emotion, can also spread in the electronic sense. In this case when the ETF algos ‘panicked’, the 'emotion' spread across other asset classes in an instant. Inconsistent and inhomogeneous trading rules across the various destinations worsened the effect. As trading halted on NYSE other destinations kept churning, but liquidity was already strangled.

 

The post-crash joint report by the SEC and CFTC notes that on the morning of the flash crash there was a decidedly unsettled feeling in the market. The European debt crisis was top of the list, and risk indicators included higher premiums on credit default swaps for debt from Greece, Portugal, Spain, Italy, and Ireland and a weak Euro. The VIX shot up by over 30%, the fourth largest single-day increase. Prices on gold futures rose 2.5%, while yields of ten-year Treasuries fell nearly 5% as investors engaged in a “flight to quality", said the report.

 

Clearly it wasn't a good day to sell; but we all make mistakes. The report highlights just how easy it is to make a well-intentioned trading faux pas that can wipe hundreds of billions of dollars off the market within minutes.

 

Lessons have been learned and they will help to prevent another flash crash. I have some to add:

 

  • Perform comprehensive pre-trade analysis, including by backtesting algorithms under a wide range of circumstances using realistic market simulation – If the mutual fund in question or its executing broker - had done a thorough back-test of its trading strategy, using some of the dire indicators and conditions present, it might have thought twice about selling so aggressively - possibly preventing the crash.
  • "Light up" the algorithmic trading process. Visibility during the trading process is crucial. Market monitoring and surveillance technology exists than can monitor the markets for anomalous behavior and alert the parties involved if it is spotted. Red alerts should have been going off in the broker, with real-time risk analytics highlighting impending problems. Also, the regulators should have been able to see an “early warning” and respond from a NORAD-style monitoring HQ.
  • Homogenize trading rules across all exchanges and ECNs. When one halts trading they all halt - for the same reason and for the same amount of time.

 

Gary Gensler, chairman of the CFTC, said following the report that perhaps both brokers and customers need to be obligated  "to monitor and make non-disruptive trading judgments." As Mr. Gensler noted, high volume is not necessarily an indicator of real liquidity. The more visibility we have into trading, the more responsive we can be and the more likely we are to avoid another flash crash.