« September 2010 | Main | November 2010 »

October 2010

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.


Wednesday, October 13, 2010

New Wall Street film shows that technology never sleeps

Posted by Giles Nelson

After encountering the latest Wall Street film ‘Money Never Sleeps’ earlier this week, it’s apparent that it's not just the then-brick-sized mobile phones that have changed since the 1987 installment.

The movie opens with Gordon Gekko, the man who so famously stated, “greed is good” in the first film, being released from jail. It’s a comical scene contrasting the technology of the ’80s to the tech of today, as the guard returns Gekko’s bulky mobile phone. Gekko is released into a world where the nature of how the financial world is run has completely changed. However, it was only after recently revisiting the original movie, you come to realise just how much advances in technology has fundamentally changed the way in which the trading floor environment operates.

Take High frequency trading (HFT), the use of technology to monitor and submit orders to markets extremely quickly, which has been receiving a lot of bad press recently and is sometimes described as “abusive”. It is no more abusive than two traders making trades using only the telephone, as was the case in a scene from the original Wall Street film.

Yes, it can be used for rogue trading by the likes of Gekko, but so can any other technology. Technology itself is morally neutral. Similarly, algorithmic trading is also seen by some as an industry curse. Credit Suisse has been fined this year by an exchange after its algorithmic trading system went out of control and bombarded the exchange with hundreds of thousands of erroneous orders. However, this wasn’t a deliberate attempt to manipulate the market. It was a mistake, albeit a careless one. There just weren’t proper controls in place to protect the market from what, ultimately, was human error – the algorithms hadn’t been tested sufficiently.

There is no doubting that technology has generated enormous benefits for trading – greater efficiencies, more market liquidity, tighter spreads and better prices for all. To lose these benefits because of perception would be very dangerous. Having said this, technology has also made the markets faster and more complex. Therefore, all market participants need to up their game by deploying modern day monitoring capabilities to spot trading anomalies to help capture the next generation Gekkos.

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.


Monday, October 04, 2010

No evil algo-trader behind the flash crash

Posted by Giles Nelson

The long anticipated joint SEC and CTFC report on the 6 May 2010 flash-crash came out last Friday.

After reading much of the report and commentary around it, I'm feeling rather underwhelmed.

The root cause of the flash-crash, the most talked about event in the markets this year, was a boring old "percentage-by-volume" execution algorithm used by a mutual fund to sell stock market index futures. How banal.

The algorithm itself was simple. It just took into account volume, not price, and it didn't time orders into the market. Many commentators have pejoratively described this algorithm as "dumb". It may be simple, but it's one of the most common ways that orders are worked - buy or sell a certain amount of an instrument as quickly as possible but only take a certain percentage of the volume available so the market isn't impacted too much. The problem was the scale. It was the third largest intra-day order in the E-mini future in the previous 12 months - worth $4.1Bn. The two previous big orders were worked taking into account price and time and executed over 5 hours. The flash-crash order took only 20 minutes to execute 75,000 lots.

It wasn't this order on its own of course. Fear in the markets created by the risk of Greece defaulting was already causing volatility. Stub quotes (extreme value quotes put in by market makers to fulfill their market making responsibilities) appear to have contributed. There was the inter-linking between the futures market and equity markets. There was the very rapid throwing around of orders - described as the "hot potato" effect, certainly exacerbated by the many high-frequency traders in the market. There was the lack of coordinated circuit breakers in the many US equity markets. There was the lack of any real-time monitoring of markets to help regulators identify issues quickly.

High-frequency and algorithmic trading have been vilified in many quarters over the last months. I think many were expecting that the flash-crash cause would be a malignant algo, designed by geeks working in a predatory and irresponsible hedge fund, wanting to speculate and make profits from "mom and pop" pension funds. It just wasn't anything of the kind.

The flash crash has raised important issues about the structure of multi-exchange markets, the role of market makers, the lack of real-time surveillance and how a simple execution strategy could precipitate such events. I do hope that the findings in the flash-crash report will ensure a more balanced view on the role of high-frequency and algo trading in the future.