New research from the Federal Reserve Bank of Chicago finds widespread risks to market safety due to high-speed trading.
As part of a new study, Fed researchers interviewed more than 30 technology vendors, clearing dealers, proprietary trading firms, futures commission merchants, and exchange and clearinghouse professionals. They found that, “out-of-control algorithms were more common than anticipated prior to the study and that there were no clear patterns as to their cause.”
It says that two of the four clearing dealers, two-thirds of proprietary trading firms, and every exchange interviewed had experienced one or more errant algorithms. The study also found that there may be times when no single entity has a complete picture of a firm’s exposures across markets.
Some of the reasons for these trading issues despite the various levels of controls, it notes, include: trading firms applying fewer pre-trade checks to some trading strategies than others, in order to reduce latency; that some firms do not have stringent processes for the development, testing, and deploying the code used in their trading algorithms; and, erroneous orders may not be stopped by some clearing dealers because they are relying solely on risk controls set by the exchange.
“Interestingly, market participants at every level of the trade life cycle reported they are looking to regulators to establish best practices in risk management and to monitor compliance with those practices,” it says.
The paper recommends a number of controls that could help mitigate risks, including limits on the number of orders that can be sent to an exchange within a specified period of time; a ‘kill switch’ that could stop trading at one or more levels; intraday position limits; and, profit-and-loss limits that restrict the dollar value that can be lost.
Additionally, it says trading firms should have access controls defining who can develop, test, modify, and place an algorithm into production, as well as quality assurance procedures for the code and development processes. Clearing firms should periodically audit these access controls and quality assurance procedures, it adds.
“These are only a few of the practices that could potentially help to control erroneous trades in a high-speed trading environment,” it says. “Each level of the trade life cycle should also have a risk manager who can respond quickly if exposures exceed pre-set limits. More generally, regulators should work with the industry to define best practices and to audit firms’ compliance with them.”
“At the very minimum, it is critically important that each firm involved in the life cycle of a high-speed trade has its own risk controls and does not rely solely on another firm in the cycle to manage its risk,” it adds.