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April 2011

Wednesday, April 13, 2011

Can Anything Be Done To Prevent A Second Flash Crash?

Posted by Dan Hubscher

May 6th, 2010 lives in infamy in financial markets; a precipitate dive on the US stock market wiping a trillion dollars off the value of equities in just under 30 minutes stunned the industry.

The speed at which such an astonishing crash took place was partly in thanks to the ever-shrinking timeframes in use in electronic trading methods such as algorithmic and high frequency trading (HFT).  These techniques eventually find a welcome home in many markets due to lower costs, smaller spreads, and the ability to capture alpha.  But the damage that results when automation goes awry - or is used improperly - shows that high speed trading does require high speed controls. 

As the days and weeks wore on after the flash crash, regulators realized that they had neither the tools nor the authority to look closely enough and explain what had happened. HFT and algorithmic trading were so embedded in daily market transactions that the volume of trades simply could not be tracked easily.

Since the flash crash, US regulators have been traveling two roads.  On one road, the regulators remain focused on cleaning up domestic equities trading, to prevent another flash crash.  On the other road, regulators are reforming OTC derivatives trading in response to the global financial crisis, by mimicking the market structure and transparency of the equities market, as if the flash crash had never happened. Meanwhile, markets have continued to evolve as HFT continues to spread out across exchanges around the world.

Not only are algorithmic and high frequency trading taking a growing share of activity in equities, but they are also spreading into other asset classes, such as commodities, currencies, and a wide variety of complex derivatives. The proliferation of HFT in new asset classes begs the question: are we now headed for a second flash crash?

The honest answer is: probably. And not just in equities. The interdependence between some of these asset classes also means that the crash could 'splash' across them. The use of high frequency trading strategies has already achieved dominance in stock exchanges, and migration into other asset classes and other national markets causes concern. For example, we have already seen algorithmic trading spreading beyond equities and commodities to currencies and fixed income.

A mini flash crash in Japanese yen in March was eerily reminiscent of the May 6th equities crash. If liquidity in the FX market, which trades trillions of dollars daily, could instantly dry up then there is clearly a need for better monitoring and controls in that asset class.

Measures needed to prevent a second flash crash from taking place include both regulation and technology. Market surveillance and monitoring across the board has to include regulators, trading venues, and brokers in order to be effective.

Being responsive - and responsible - means being proactive; measures have to be put into place before the next flash crash. To make this happen, sophisticated real-time surveillance is a must for monitoring anomalous market patterns, including abuses and errors; for checking sponsored access clients' credit risk; and for balancing market position limits. None of these techniques replace the need for standard compliance tools such as historical looks and material penalties for those who stray from regulatory mandates.  But the flash crash has showed that there’s an additional need to protect our markets from the damage that can’t be fixed at the end of the day.  Don't wait until it is too late, that's like driving while looking in the rear-view mirror.


Tuesday, April 12, 2011

Why Is There Currently So Much Confusion Around FS Regulation In The UK?

Posted by Dan Hubscher

Tomorrow after TradeTech we’ll be asking the crowds, ‘what’s next in regulation?’ I imagine that answers will be as varied as some of the statements provided in the recent Raj Rajaratnam insider trading investigation.

Looking at the dialog to date foreshadows some answers.  Some people are aware of specific new measures, such as the FSA’s new Remuneration Code and considerations around how Basel III will be implemented, particularly when it comes to stating the percentage of capital reserve the banks will be allowed to hold. Many are interested in the coming pan-European impacts of MiFID II, which will be quite dramatic. Some look to the role of the FSA itself – how its internal reorganization might give clues to a new approach to financial regulation, and what steps need to be taken to prepare for the regulator’s new powers.  Surely, the continuation of the FSA’s ARROW visits are top of mind for most brokers, at least.  And many seem to be wondering what knock-on effects the US Dodd-Frank legislation and resulting regulatory rules will have in the UK and elsewhere.  Others already sigh in resignation or complain that regulation is coming faster than Warren Buffet’s next attack on social network investment.

It seems that almost every week new measures are being considered and new Acts are becoming law. It is clear that governments in the West still see the way markets are run as a problem to be put right, and the answer is always more regulation. In contrast, those involved in the industry see that regulations made in haste can cause more problems than they solve.

So, what we need when it comes to looking at what’s next in regulation is open dialogue and clear consultation processes to ensure industry voices are heard. Regulators need guidance from the industry on what questions to ask when addressing new markets and the advent of new technologies arriving in different asset classes. Dialogue must be appropriate and meaningful, with regulators acknowledging that the industry has already moved ahead with its own answers to the problems caused by the global financial crisis.

On the flip side, financial services institutions also need to take action to address the market uncertainty caused by the rapid rate of regulatory change. Instead of ignoring stories in the press about new moves to control everything from the minimum capital reserve requirements to the latest attempt to clamp down on proprietary trading and credit default swaps, it is high time they examined what lies within their own control, and put in place a strategy to become proactive around regulation. 

Here again, these institutions need agility ‘built in’ to their businesses and technologies. A rigid infrastructure won’t change by itself as deadlines draw closer. Instead, market participants need to modify their trading and compliance strategies on their own terms, quickly adapting to new regulatory threats, and to new opportunities as well, without disrupting the entire business each time it needs to turn a corner.


Monday, April 11, 2011

How Fast Is Fast Enough?

Posted by Dan Hubscher

When thinking about technology and speed, the usual issue that springs to mind is how fast a transaction can take place.  Gone already are the days when every millisecond mattered; now we count in microseconds.  Or nanoseconds.  And debates already rage about the possibility of picoseconds, as if that’s all that matters.  Regardless of where you fall on the low latency spectrum, you can’t ignore the other side of speed – rapid customization. 

A new trading idea may work on the microsecond timescale, or nanosecond, or wherever the realistic limit is for any particular firm.  But the idea won’t be unique for long.  The question is, then, how to deploy that idea to the market first?  Specifically, how quickly can a new technology itself be implemented?  How quickly can a trading strategy be modified – the first time, the second time, the fifteenth time, to suit new market opportunities as they emerge?  How quickly can the expression of a trader’s intellectual property start delivering operational benefits and competitive advantage?  And, how quickly is that advantage eroded by others who are similarly responsive?
The customization frontier of algorithmic trading competition is especially pertinent when new regulatory measures are announced.  Today’s traders face dramatic change across asset classes and geographical boundaries.  Those who can implement compliant strategies the fastest not only stay on the right side of the law, but can attract new business by entering new markets ahead of the competition.
TradeTech 2011 starts tomorrow in London. There, technology providers, market operators, and market participants will meet to discuss the latest and greatest developments in our industry. The first question from buyers is always ‘how fast?’ instead of ‘how much.’   But as pent-up demand starts to accelerate, as budget starts to be released for new technology projects, traders and CIOs alike need to know their new ideas can be executed quickly.  The necessity is more than just quick return on investment; it is also getting ahead of rivals. Urgency is the modus operandi.
To meet this need, businesses need two kinds of responsiveness. The ability to respond to opportunities in real-time is imperative.   But, businesses also need agility ‘built in’ to their technical infrastructure. With new rules being laid out in both the US and Europe, buying something that was pre-defined in a previous era and closed to further change won’t work as deadlines draw closer. Agility will become the watch-word of purchasing decisions – and, undoubtedly, a major theme of conversations at TradeTech this week.