Current Affairs

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.


Wednesday, January 26, 2011

US and UK to Lose Ground as Algorithms and HFT Emigrate

Posted by John Bates

High frequency and algorithmic trading will blossom in emerging markets such as Brazil and India, possibly signalling the end of US and UK dominance in financial markets.

Even as regulators in the US and Europe debate over how to regulate algorithmic and high frequency trading (HFT), firms in emerging markets such as Brazil and India are embracing the trading practices. US and UK proprietary trading firms and hedge funds are opening offices in emerging markets centers, partly to take advantage of these budding opportunities. But there is more than greener pastures calling them; stricter regulations in the US and UK may force large banks and hedge funds to trade in - or move to - more lightly regulated regimes. This mass regulatory arbitrage emigration could signal the end of US and UK dominance in financial markets.

Brazil is attracting HFT like bees to honey. The world’s tenth largest economy, Brazil's exchange, BM&FBovespa, trades everything from cash stocks to commodity futures. The exchange has recently undertaken steps to further automate trading in an effort to capitalise on investor interest and gain more business from outside the country. Almost 90% of trading is now done electronically and about 10% on the floor. Demand for connectivity and trading access to the Brazilian market is increasing; exchanges are helping to upgrade Brazilian exchange platforms and bridge the gap between Brazilian markets and non-Brazilian traders (and vice versa). Technology vendors are building ticker plants for real-time, low latency market data as well as adding connectivity and algorithmic trading capabilities. And brokers are clamouring to join up with, or buy, Brazilian brokerage firms to help smooth the path for non-Brazilian customers - which by law must have local representation.

Algorithmic trading in India is also taking off. Spending on software for algorithmic trading is going to be easily worth $100 million in two years. The market share of algo trade will rise from 15 per cent at present to 50 per cent in the next three years. The number of trades on the NSE (National Stock Exchange) are 10 times that of the London Stock Exchange. Both NSE and BSE (Bombay Stock Exchange) are offering co-location facility; smart order routing and mobile trading has now been allowed, too. Also, commodity exchanges are catching up on algo trading. It is being put to use in foreign exchange derivatives too. That’s an enormous reason to do algorithmic trading. Smart order routing will force inefficiency out of the market, reduce price discrepancies between the two main equity exchanges and increase competition. (NSE’s process of validating every algo was putting a significant brake on its growth. The process is unsustainable and will be short-lived.)

Turkey’s main bourse, the Istanbul Stock Exchange, was the latest to open up to HFT and algo trading, according to the FT. Mexico is opening up, as are Asia Pacific markets in Japan, Australia, Singapore and Hong Kong. Bulge bracket banks, large hedge funds, and buy-side firms are all gearing up for the next onslaught of HFT in these areas, which may take business away from the more regulated markets.

Few of these markets are as heavily regulated as the US and Europe for this kind of trading. But regulated or not, any market that embraces HFT and algos has an obligation to make sure that they will not cause new issues such as flash crashes. Mandatory pre-trade risk and market surveillance should be there within the regulators and the exchanges. Regulators have had a rear-view mirror approach when it comes to understanding market software. They do not have the capability to know what is happening on a real time basis. The technology that SEC, the US stock market regulator, was using was two decades old. Regulators have to catch up here. All parties in the trading cycle should take more responsibility to ensure appropriate risk control and surveillance. Then perhaps algo trading can be fluid, with risk managed across borders. And the dominant players will go with the flow, retaining their HFT crowns.


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 ( or CME’s test algo that fired phantom orders into the market in September ( 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 ( 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. ( 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.

Thursday, September 30, 2010

Preventing an HFT Witch Hunt

Posted by John Bates

 "For a charm of powerful trouble,

Like a hell-broth boil and babble


Double, double, toil and trouble,

Fire burn, and caldron bubble."

William Shakespeare.


There is no shortage of news about the evils of high frequency trading these days; almost as if the whole thing is turning into a witch hunt. According to Wikipedia: "A witch-hunt is a search for witches or evidence of witchcraft, often involving moral panic, mass hysteria and lynching". I don't think we will get so far as lynching, but a certain amount of hysteria and moral panic are certainly present in the marketplace.


NY Senator Charles Schumer is keeping HFT in the headlines, recently claiming the players pulled out during the flash crash "leaving a dearth of liquidity and exacerbating market volatility." Last week SEC Chairman Mary Schapiro told the Security Traders Association ( that she was concerned about not just HFT but also whether high frequency players should be regulated in "key aspects of their market behavior, including quoting and trading strategies.”


She also expressed concern over execution algorithms: “Even with checks for ‘fat finger’ errors and other problems, these algorithms can quickly generate a volume of orders that swamps the immediately-available supply of liquidity for a stock.”


And most recently, the Investment Company Institute, a trade association for fund managers, is said to be meeting in Washington, D.C. to push for a plan to restrict high-frequency trading. Some ICI leaders contend that HFT profits may come partly at the expense of ordinary investors (


I'd like to turn the fire down under the witch's cauldron and avoid a witch hunt. Like witches, HFT is not evil - just misunderstood. Witches of lore used the tools at their disposal, whether eye of newt or toe of frog, to get the job done. There was never much evidence that the job in question was evil-doing, but they were persecuted nevertheless. The same can be said of HFT and algorithmic trading. They are just some of the trader's tools that help to get the job done efficiently, and are also misunderstood.


Algorithmic trading and HFT are less like witchcraft and more like gold mining. When gold is discovered a rush ensues and everyone descends upon the territory. Then they have to pan for gold in rivers or dig to find the hidden seams of gold. Using algo and HFT trading firms are always seeking out new opportunities and trying to mine the gold before others descend.


I'm not saying that there are no issues with HFT. It can scale the capabilities of a trader hundreds or thousands of times - which can of course increase trading risk accordingly. But rather than burn the witch, or HFT, we need to find ways to control the risk.


High frequency pre-trade risk capabilities will help. Using a real-time pre-trade risk firewall it is possible to continuously recalculate risk exposures while monitoring trades as they go to market -  and determine what impact they would have on pre-defined risk limits.


Using back-testing and market simulation is another; before algos go live it is possible to see how they would perform in production. Real-time market monitoring and surveillance allows more rapid response to potential crises and market abuse – potentially allowing rapid action to prevent or minimize any market impact. Finally, keeping an audit trail of market data and potential abuse cases is also important. Tick databases can be used here.


The thing to remember is that HFT and algo traders are not evil witches. There are many positive aspects of algorithms and HFT. They minimize 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. Rather than organize an HFT witch hunt and run around shouting and carrying torches it would be much more productive to look at how HFT can benefit from effective controls. We must be careful not to over-regulate and damage this important economic engine.


Monday, September 27, 2010

Mystery Solved, but Questions Remain

Posted by John Bates

Scooby Doo and the gang have been investigating the spooky mystery of the "phantom orders" on CME and they found out that the culprit was... wait for it.... The CME! Turns out the exchange plugged in some new contracts to try them on for size and they mistakenly went live and bam! they got traded.

According to the FT, CME Group said it had “inadvertently” posted test orders intended for its quality assurance procedure on Globex ( CME said the company tests its systems as a matter of course and it had not determined whether human error or a computer glitch caused the mistake.

The FT said the mistaken order flow began at 3:38pm ET time on Monday, September 13th and lasted for six minutes. Futures brokers noticed oddly anomalous spread price activity during that period, when trading is usually slow.

CME said it was working with the customers that somehow managed to trade these contacts in those six minutes, and says it won't "bust" the transactions. Fair enough. But the mistake shows how the exchange lacked adequate monitoring technology to see that some test contracts had entered the live environment - and were being traded.

This six minute phantom orders mystery is solved, but the very fact that it occurred supports my argument that brokers, traders and exchanges need to have more advanced capabilities to detect problems and abuse as they happen, and recommend actions to take in response. The Mystery Machine got to the bottom of the case, but it was not fitted with the latest real-time surveillance equipment. It seems, like Velma, the CME temporarily lost their glasses!

Wednesday, September 15, 2010

I Would’ve Got Away With It Too - It If It Wasn’t for You Pesky Kids….

Posted by John Bates

Strange things are happening in the markets! As you know if you’ve been following this blog, quite a few scares, horrors and apparitions have been sighted in equities, futures, FX and oil markets over the last few months. But fortunately the Mystery Machine has rolled into town and Scooby, Shaggy and the gang are investigating…


The latest spooky mystery is “phantom orders” that appeared to scare participants on the CME (read more about it here). For 6 minutes on Tuesday unexplained orders, that could have been caused by a “fat finger” error or an “algo gone wild”, caused CME to use Rule 587 which gives them powers “including without limitation, closing the market, deleting bids and offers, and/or suspending new bids and offers”. So although they weren’t sure what was going on – the CME were at least able to respond.


Another report this week shows how those involved in alleged market abuse are starting to be unmasked. Last week I wrote a blog posting called “Algos Can Get Stuffed” which was also featured on the Tabb Forum. In it I talked about the possibility of firing orders into the market with the intention of misleading the market or slowing the market down – and even how some link this phenomenon with the flash crash. This week a trading firm called Trillium was fined by FINRA for using illegal trading practices (read more about it here).  Trillium was fined $1m for sending orders aimed at deceiving investors. Nine traders entered buy and sell orders in patterns that aimed to manipulate the prices of instruments. And they did this 46,000 times! This “layering” enabled Trillium to trade at a profit once they’d manipulated the price.


These 2 incidents show that awareness of the problems we’ve been writing about on this blog have increased radically. Trading venues are more aware that algos gone wild and fat fingers can cause market panics and manipulate prices. Regulators are more aware that high frequency trading can be used as a weapon for market manipulation.


But we can’t rest on our laurels. Maybe we got lucky this time. As market data volumes continue to increase we need to have more advanced capabilities to detect problems and abuse as it’s happening, and recommend actions to take in response. Let’s ensure the Mystery Machine is fitted with the latest real-time surveillance equipment. Let’s enable the gang to unmask more villains at the haunted “high frequency manor” inspiring the legendary outburst of “I would’ve got away with it if it wasn’t for you pesky kids….”

Wednesday, September 08, 2010

Algos can get stuffed!!

Posted by John Bates

As regulators continue to look into the causes of the May 6th flash crash, some high frequency trading approaches are coming under scrutiny. In particular the concept of “quote stuffing”, where algorithms send so many orders into the order book that the market cannot possibly respond, has come under fire from market participants and the press.


The SEC, having reportedly decided that quote stuffing probably did not have a major role in the flash crash, is now taking aim at the practice to see if it puts some investors at a disadvantage by distorting stock prices ( The CFTC is looking at data from database developer Nanex and mulling how to address quote stuffing in futures markets (


Meanwhile, concerning incidents continue to happen in the market. As recently as last week there was an incident that caused Christopher Steiner at Forbes to write a story called “Did we dodge another flash crash on September 1st?” The story describes how on September 1st at 10am quote volumes ballooned - as they did on May 6th. In fact quotes reached 275,000 per second, as opposed to 200,000 on May 6th. Unlike the flash crash though there wasn’t a dramatic fall in prices. However, the bids and offers did cross for a time – leading to high frequency traders taking advantage of arbitrage opportunities. This data was exposed again by firm Nanex – and left the market wondering if quote stuffing by high frequency traders was behind the spikes.


The world is waking up to the fact that high frequency and algorithmic trading have quietly become part of the market fabric, and the world does not seem to be too happy about it. HFT and algorithms are being "demonized" said the FT article, and I agree. I also think the hype is overblown.


Once trading became automated, trading strategies naturally morphed to take advantage of the available technology and higher speeds. High frequency statistical arbitrage techniques can also mean more order cancellations, some of which may - wittingly or unwittingly - fall into the quote stuffing category. Those involved in intentional quote stuffing as a strategy need to be held to task. But to demonize all strategies or call for banning them is a step backward. What is needed is a framework by which to police them - and to prevent them from going wrong. The technology to do this is already available. For example, an area I’ve had a lot of experience in is the use of complex event processing to provide a platform for high frequency, multi-venue market surveillance. With such a system quotes can be monitored to determine how many quotes per second there are on each ticker symbol, the ratio of quotes to trades, when large spikes are emerging and many other interesting real-time analytics and patterns that it’s useful to track in real-time.


But regulation of high speed trading practices has fallen short to date. Regulators have not had the funds, the technology, the power or the expertise to follow and control high speed trading. However, it is good to see that progress is now being made. CFTC commissioner Bart Chilton wrote last week in an article entitled Rein in the cyber cowboys: “There may be some cyber cowboys out there and they could be giving respectable traders a bad name”. His colleague CFTC commissioner Scott O'Malia told Reuters last week that, if traders are flooding the market with orders with the intention of slowing others down, the regulator would consider addressing quote stuffing under new rules in the financial regulation bill that deal with disruptive trading practices.


It is possible that quote stuffing is causing more problems that just slowing down the natural flow of trades. Trading behavior patterns suggest that these quotes are a distraction to other traders. There are patterns evident where the quote "stuffer" continuously traded first - possibly by distracting others. And the disruption can cause the bid and offer to cross – providing a nice arbitrage opportunity for those who are not distracted! All of this needs to be looked into further. I fully support the CFTC and SEC's efforts to get to the bottom of not just the flash crash, but HFT and algorithmic trading practices. They are now integral in the equities and futures markets, and increasingly so in FX, fixed income and energy. What we need is better policing of the markets to protect the honest ranchers from the cyber cowboys.