Compliance (MiFID, RegNMS)

Wednesday, June 01, 2011

All Aboard: New Regulations Take Many Tracks

Posted by Dan Hubscher

The regulatory trains in Europe and the US have left their respective stations and are headed down the tracks, but they will change tracks many times along the route before reaching their destination. Thick tomes of proposed operating rules have to be interpreted even as interested financial services parties line up to persuade regulators to change tracks (in order to accommodate their particular demands). Passengers should be prepared for delays.

The significant regulatory rethink in Europe on two levels - derivatives and MiFID II, combined with the slow-drip interpretation of US Dodd-Frank rules are leading to a thick “London Fog” on both sides of the pond.  While some market participants are wanting to act but experiencing confusion and misunderstanding, others are quite clear in their approach to the unknown – wait and see.  From banks to brokers and funds to financial advisors, everyone is looking for clarity.

What we know so far is that both regions want to move as much OTC trading as possible onto clearing platforms; and both support setting position limits by trader type to try and spot speculative activity. The US and the UK support splitting banking activities from speculative, or proprietary, trading. The US, UK and EU all seem agreed that hedge funds should at least be registered. All are under short deadlines to implement new rules.  Some deadlines from the Dodd-Frank Act are slipping, while others remain intact.  And MiFID II’s draft publication is scheduled for July.

There is an additional kink in the UK's track, where there is an impression of a regulatory void now that the Financial Services Authority is being broken up

While the US and Europe hurry to regulate the rest of the world has to scurry to catch up. Until the G20's plans are in place in late 2012 there is a lack of harmony - a global regulatory framework that is full of holes and pitfalls. Regulatory arbitrage is a hot topic and has already begun with the shift of trading personnel to more lightly regulated areas. Transparency is not well served by disparate regulatory frameworks.

The ultimate goal for regulators has to be visibility; the ability to see across geographies, asset classes, exchanges and market participants. Cross border trading is a reality and problems can happen - as we’ve seen - so regulators do need to cooperate, just as we are already seeing with the US and UK.

Market participants cannot really afford to wait for regulatory harmony, however, nor can they wait for local regulatory clarity to satisfy their own need for visibility. Hot button issues such high frequency trading, algorithmic trading, dark pools and flash crashes (or splash crashes) may all be clarified in due course. But likely some issues will remain open for a long time to come.  Regardless, firms need to move forward now, carefully of course, in order to move smoothly into compliance.

Despite all the noise to do with algo and high frequency trading, the changes that regulators and exchanges are making are to try and better contain HFT issues, not to take HFT away.   How trading is conducted and governed may change, but liquidity, reduced spreads, and lowered trading costs need to stay.

Using surveillance and monitoring technology alongside HFT will not entirely prevent flash crashes or fat fingers, but it will go a long way toward helping you to protect yourself when these things happen. If you can sense problems and protect yourself when something untoward occurs, you won't get caught in a 'deer in the headlights' moment. 

Don't be the guy standing on the track when the train comes along. The 'deer in the headlights' will not win against the barrelling train. Be the guy (or the deer) who heard the whistle and got safely out of the way. 



Thursday, May 26, 2011

Preparing for changes in the regulatory approach

Posted by Richard Bentley

Richard BentleyIn this short video we ask our experts how regulatory change will affect market participants, and the markets themselves. Without a crystal ball to predict the future, firms still need to be compliant, while trying to pre-empt the direction of regulatory reforms that are not yet finalized. This will inevitably cause business disruption. The following spokespeople give their views on how brokers, exchanges and other participants might begin to prepare themselves:

  • Dan Hubscher, Capital Markets industry marketing manager, Progress Software
  • James Godwin, director of regulation, PLUS Stock Exchange
  • Dave Tolladay, director, Alerts4 Financial Markets

As Dave Tolladay puts it, “The wrong answer is to do nothing.” So what is the right answer? How do banks emerge as leaders from this time of change?

This is Part 2 of our 4 Part market surveillance video series. Here's Part 1 in case you missed it: Cutting through the confusion of financial regulation.

Friday, May 20, 2011

Cutting through the confusion of financial regulation

Posted by Richard Bentley

Richard BentleyGovernments around the world seem to view increasing regulation as a way to control the financial markets and avoid future crises. But agreeing and implementing new regulation takes time, and when the markets move as fast as they do it can seem like a constant game of cat and mouse as the market tries to keep up with regulation, and regulators try to keep up with the market.

With changes in regulatory approach taking place with Dodd-Frank in the US, EMIR and MIFID II in the Europe and changes to the role and remit of the FSA expected in the UK, it can be hard for platforms, traders and other market participants to know what to prioritise to stay they right side of the law. In this short series of video interviews, we ask experts in market surveillance for their opinions on:

  • What’s causing confusion around financial regulation
  • How traders can prepare for changes in the international regulatory approach
  • How regulatory changes will affect traders
  • And how they can use technology to prepare for regulatory change, looking specifically at how market surveillance technology can help.

We also speak to James Godwin and Tony Harrop at PLUS Stock Exchange about how they are addressing these issues, and how they are using the Progress Apama solution to remain compliant.

Video 1: Why is there so much confusion around regulation?

At the recent TradeTech event in London, voices from around the world echoes the same concerns: with so many changes in regulation, especially for those operating internationally, it is hard to know what to prioritise, how to prepare and where to start. In short, there is a lot of confusion in the marketplace.

In this video we speak to:

  • Dan Hubscher, Capital Markets industry marketing manager, Progress Software
  • James Godwin, director of regulation, PLUS Stock Exchange
  • Dave Tolladay, director, Alerts4 Financial Markets

Gauging their opinions on this issue, we look at where the confusion is coming from and how market participants might begin to address it.

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.


Thursday, March 24, 2011

Detection, Prevention, Deterrence (oh my! )

Posted by Dan Hubscher

It is gratifying to see the serious attention that regulators, traders, brokers and the buyside are paying to market surveillance today. It was not always the case. The credit crisis began a domino-effect market crash that rang alarm bells and woke them up; then the flash crash jolted them like a cup of three-shot espresso on an empty stomach.  But, despite the attention and the good-spirited attempts to put monitoring and surveillance into place globally, the changing face of regulations can create fragmented and inconsistent results.

Market surveillance today resembles a patchwork quilt, some programs monitor in real time and others look backward, said Miranda Mizen, Principal of TABB Group in a paper entitled Dynamic Surveillance: Detection, Prevention, and Deterrence.  Brokers' internal risk controls are differentiated from their clients' - for those that actually use pre-trade risk controls on their clients, not all do yet. Exchanges have varying surveillance programs and have operated in a siloed environment, with disparate procedures and processes causing a disconnect with their colleagues.

Mizen said that the drive to create more dynamic, comprehensive programs and techniques boils down to three core objectives: detection, prevention, and deterrence.

Detection of market abuse while, after, or even before it happens will help to bring back investor confidence.  Prevention of fat finger trades and rogue algorithms entering the market will go a long way to avoiding more flash crashes, or even splash crashes across asset classes. Prevention is rapidly becoming the domain of brokers, which sit squarely in the middle between order flow and trading venues.

Deterrence via real-time monitoring, fines and convictions should help to clamp down on market abuse. Although it will never be completely stamped out as long as it seems profitable, new policing techniques will up the ante so abusers will also have to up their game, said Mizen.

Consistent, viable market surveillance across the board has to include regulators, exchanges and ECNs, brokers and buyside firms in order to be effective. Sophisticated real-time surveillance is crucial for monitoring market patterns, for checking sponsored access clients' credit risk, for balancing position limits. It needs to be coupled with historical surveillance in order to compare market movements and flag possible abusive patterns.

The demand for sophisticated real-time surveillance adds to, rather than replaces, historical views, and the two increasingly overlap. Both are essential. For example, a client's credit risk needs constant monitoring (real-time) for sponsored access, but the global credit risk may not be verified until the overnight processes (historical) have run, said Mizen in her paper.

Real-time and historical pattern detection can also complement each other. If there is market activity several standard deviations from the norm within a two-minute window it could raise an intra-day red flag to the regulator, yet concluded to be non-abusive. If, however, this same activity surfaces at the broker along with correlated activity in another asset class during an overnight data crunch - it looks more suspicious. Real-time or historical, surveillance of flow and markets needs to be programmed tightly enough so that the patterns are not falsely alerting officials. 

Mizen said that of the three - detection, prevention and deterrence - prevention needs the most focus to protect markets and prevent disruptive, destructive order flow.  If using a combination of sophisticated real-time and historical surveillance tools can prevent another flash crash, stop market abuse in its tracks, and help to catch and punish wrongdoers it will go a long way to bringing back investor confidence.


Tuesday, March 22, 2011

An Endless Game of Hide and Seek

Posted by Dan Hubscher

Market surveillance needs permeate financial services firms from pre-trade to settlement, from trading via instant messenger services to exchanges and ECNs like never before in history. Every message, every trade, every conversation, every Tweet must be recorded, taped and downloaded into a database for on-the-spot or future scrutiny. Surveillance is necessary in order to provide full visibility to trading activity, whether via trade order flow, e-mails, Twitter, social media sites like Facebook or phone conversations. It’s invasive, there’s nowhere to hide.

U.S. hedge-fund managers are going so far as hiring security firms to comb their offices and homes for listening devices, according to new reports, reacting to the government’s insider-trading investigations. U.S. prosecutors used cell phone conversations as part of the evidence in the Galleon insider trading case. In the same vein, the UK's FSA has recently extended the recording of cell phones to hedge funds, and expanded taping rules for brokers to include all voice and electronic communications. If authorities are searching people’s homes for evidence against them, this illustrates the lengths to which they will now go to catch insider trading. And compliance officers need to be on top of this in every way they can.

Miranda Mizen, Principal at TABB Group and author of the paper entitled Dynamic Surveillance: Detection, Prevention and Deterrence noted that investor confidence took a beating after the May 6th flash crash, adding to the thumping it took during and after the credit crisis.

"Intentional and unintentional disruption and behavior rocks investor confidence and every crisis and regulatory change increases the demand for better supervisory and monitoring techniques," said Mizen in the report.

Intentional behavior such as spoofing and ramping the market on the close, or insider trading need to be spotted and acted upon in a hurry. Brokers, trading venues and regulators need to know who is trading, what does it mean and is it correlated to something somewhere else?

In theory in an electronic environment it seems more likely that market abusers would be caught since so much data is captured. This, of course, depends upon the data. As monitoring and detection become more sophisticated the abuse bar is raised, but it will forever be a game of cat and mouse. Insider trading, for example, may manifest itself only in the painstaking reconstitution of conversations across multiple media, said Mizen.

The number of different places that trading activity can take place is constantly increasing. What used to be done exclusively in a trading firm's office at the trader's desk can now happen via cell phone - maybe by using a trading application or simply by phoning it into someone in the office.  Or a trader can begin to work a deal at the office, go for lunch and finish it via instant messaging with his broker.

Compliance officers need to have full visibility in order to spot and prevent abusive trading activity - and that vision has to encompass trade order flow, e-mail conversations, Twitter, social media sites like Facebook, and phone conversations - even at home. In Europe, the Market Abuse Directive extends the notion of market manipulation to cover over-the-counter (OTC) instruments that can influence the price of listed instruments.

But even as the compliance side ramps up surveillance, there is a move toward making the front office more responsible. Trading desks will increasingly ensure that they don't do anything stupid, either with fat fingers or with an algorithm that goes rogue. Surveillance procedures can actually help them to trade more effectively, knowing that mistakes will be caught.

Changes in regulation paint a scary picture for brokers, with Dodd Frank, the flash crash, the market access rule and large trader reporting all crashing onto their plates. There is a need for constant monitoring and for the data to be analysed, scrutinized and stored and retrieved on demand.

The market access rule in the US will really change the game plan; brokers will have to apply pre-trade risk controls to every client using their market access, checking order size and credit limits in real-time. Although this is a relatively simple concept at a high level, the devil is in the very high speed details, and it can create a 'speed bump' to the order process, which could damage business. This creates another challenge; the broker needs control, a view across asset classes and client positions, with as little time lag as possible.

With increasing ownership of risk across the enterprise, the growth of social media and other off-trading-floor activity, the scope of surveillance becomes broader by the day. For further insight please go to Mizen's report - Dynamic Surveillance: Detection, Prevention and Deterrence - on the Progress website.


Friday, March 04, 2011

Hurry up, Take Your Time

Posted by Dan Hubscher

The Buck Stops At The Brokerage

In Key West there is a famous cat show on the waterfront at sunset where the trainer (yes, cats can be trained) gives his performers their signals and they rush to slowly do his bidding. He says to them, often: "Hurry up, take your time." Such is the nature of cats.

Regulating the financial markets seems rather like herding cats; trying to figure out the legal angles and ramifications to a raft of new regulations while trying to consult with market participants and coordinate between other financial regimes and placate well-meaning politicians is a recipe for confusion. 

After the May 6th, 2010 flash crash there was a three month period where the regulators learned just how much they didn't know, said Miranda Mizen, Principal at TABB Group at a Market Surveillance Seminar on February 22, co-sponsored by Progress Software. And this was after nearly two years of delving into financial market practices in order to reform regulations following the credit crisis. The result of all of these events has been a slew of new regulations, all of which require new or different surveillance programs in order to succeed.

During the intricate dance between market participants and regulators it becomes clear that there needs to be some common ground from which to start. That common ground lies with brokers, concluded Mizen, author of the paper entitled Dynamic Surveillance: Detection, Prevention and Deterrence.

She noted that brokers are sitting square in the middle between client order flow and trading venues. They are the major intermediaries, handling both order flow and information which allows them a top-down view of the markets. This view could help to fill some of the gaps that regulators need to fill. 

The Securities and Exchange Commission has intimated that the buck stops with senior executives at big brokerage houses and operational risk executives, who must prove that they have adequate procedures in place to prevent market abuse. This fate was pretty much sealed when the SEC agreed to propose the Market Access Rule last year, which would effectively prohibit broker-dealers from providing customers with naked access to an exchange or ECN.  

The Market Access Rule mandates real-time risk controls for brokerage clients, but it is only part of the struggles that brokers face. They have to deal with market structure changes such as the introduction of swap execution facilities, regulations in new asset classes and geographies, and regulators' demands for more detailed trade information. The rise of social networks, often used for trading discussions, adds another dimension to monitoring challenges. Plus, their efforts toward surveillance and market monitoring must be deemed "appropriate" by the authorities.

And the sellside will be happy to know that the buyside wants these types of control in place. Mizen's report pointed to recent interviews with asset managers in Europe, 85% of whom said that performance monitoring of their order flow is their top requirement when using algorithms and direct market access. This includes preventing fat finger trades, algos gone wild and market abuse.

No one wants to inadvertently kick the first domino that causes the whole line of dominoes to fall across the market, and most market participants are terrified of being the ones whose algorithm goes rogue. Technology is one - big - part of the solution. But procedures, processes and controls are also important elements of risk evaluation. Best execution and surveillance have to work together to be effective.


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, 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.