It was an honor to sit on the CFTC Technology Advisory Committee
(TAC) last week. I was very impressed with the presentations and discussion,
chaired ably by Commissioner Scott O’Malia. I was also impressed by the other
Commissioners and with my fellow committee members. This week the CFTC has been
discussing new rules to handle disaster recovery and has also received further
coverage on one topic discussed at the TAC – that of pirate algos attacking algos
going about their normal trading business and aiming to manipulate the market.
Further coverage can be seen in this article “CFTC posits new
disaster recovery rules as regulators probe 'algo price pirates'”
The CFTC has a sensible proposal on the table to require exchanges
and clearing houses to have effective disaster recovery plans in order to
quickly recover from any market-wide disruption. After 9/11 it became clear
that many NYC-based financial services firms were not prepared for a disaster
of that magnitude, and subsequently took disaster recovery (or business
continuity as it came to be known) very seriously. Now it is time for those
virtual businesses - exchanges and ECNs - to do the same.
Operational risk is a very real issue in today's fast moving
markets, where anything can go wrong. Being able to recover and quickly start
trading again - across all exchanges and destinations - is paramount. The May
6th 'flash crash' gave us a glimpse of what can happen if something went wrong
at one exchange and the rules across other exchanges were not harmonious.
The flash crash was a man-made event exacerbated by machines.
Algorithms are programmed to do as they are told, and if one destination is not
responding they will hunt down and ping, scrape and trade on whatever others
they can find. Sometimes this can have unfortunate consequences for the market
as a whole. This is why there must be consistency across trading venues in how
they respond to crises.
At the CFTC's Technology Advisory Committee meeting last week, there
were several interesting observations about high frequency trading and algos.
We heard new analysis of the flash crash from trade database developer Nanex
LLC. The Nanex report suggested that predatory practices such as "quote
stuffing", where algos try to prevent others high-frequency traders from
executing their strategies, may have contributed to the crash. Commissioner
Chilton of the CFTC (who I had the pleasure of sitting next to at the TAC last
week), the TAC and the SEC are taking these claims very seriously. Commissioner
Chilton expressed his concern that there are algorithms out there hunting down
and interfering with other algorithms, calling them 'algo price pirates' that
may trigger a new enforcement regime. Now I believe that firms and their algos
are going to be monitoring the market with the goal of figuring out how your
algos work and devising a strategy to capitalize – that’s just the natural
order of capitalism. However, that’s different from using algo terrorism to
bully the market into behaving a particular way. That’s something we need to
watch for and prevent for it causes damage.
If such 'pirates' are to be policed and caught, the regulators will
have to sail with the pirates in shark-infested high frequency waters.
Surveillance and monitoring are critical, as is the need for speed. The speed
at which algorithms can pump quotes into a destination is daunting, so the
policemen will also need to work at ultra high velocity. I was a little
concerned when Commissioner Chilton said at the TAC meeting: "Just because
you can go fast it doesn't mean you should." I know where he’s coming from
but would modify the statement to say that in HFT it is critical to go fast to
be competitive – but you need the proper best practices, training and safety
precautions. High frequency trading, if properly monitored, need not be scary
or evil. It can contribute to liquidity and market efficiency, and provide
alpha generation. To truly address the HFT issue, real time market surveillance
technology must be adopted to monitor and detect patterns that indicate potential
market abuse such as insider trading or market manipulation. Or pirate
algorithms trying to board your strategy ship and take off with the gold
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