Smart - but is it Smart Enough?

Nasdaq liked the idea of real-time market surveillance so much that it bought one of the companies that specialize in it.

Nasdaq OMX announced this week that it will buy Smarts Group, an Australia-based market surveillance business that helps exchanges monitor compliance with trading rules.  You can read the full story here: http://online.wsj.com/article/BT-CO-20100727-712964.html.

The market moves a lot faster than it used to thanks to algorithmic trading. What has not kept pace is monitoring high speed trading. Smarts is one commercial approach that aims to enable such monitoring. However, there is a big problem with Smarts - the time it takes to develop a new surveillance scenario. I have spoken to a number of venues around the world, including the Australian Stock Exchange, who have told me they are totally dependent on Smarts to add new rules when they need one – and it takes 6 months to a year – if they’re lucky. In fast-moving markets we need to evolve in hours not years!!

Despite shortcomings with Smarts, the Nasdaq acquisition is an indicator of the importance of real-time surveillance in a post-flashcrash world. Maybe the flash crash of May 6th has a silver lining if lessons learned are leading exchanges to better use surveillance and monitoring. In the aftermath of the crash, exchanges scrambled to recover trading data and do some forensic investigation into the causes.  This proved extremely difficult probably because of inadequate analysis capabilities to pinpoint what had happened.

Exchanges, ECNs, brokers, traders and regulators all must take an intelligent approach to monitoring and surveillance in order to prevent rogue trades and fat fingers. Transparency is the key. Regulators in the US and Europe are concerned about the lack of transparency in markets where high frequency algorithmic trading takes place, as well as in dark pools.

We ran a survey at SIFMA this year where we asked 125 attendees about high frequency trading and market surveillance. A staggering 83 percent said that increased transparency is needed to effectively deal with market abuse and irregular market activity, such as the flash crash. However, only 53 percent of firms surveyed currently have real-time monitoring systems in place.

Nasdaq says that Smarts will be used to expand broker surveillance solutions, which I take to mean monitoring scenarios such as sponsored access. This would be a smart move (forgive the pun). With naked access, high frequency traders can plug straight into an exchange through their broker – and it’s critical that pre-trade risk and surveillance is in place to prevent a crisis in which wild algos could cause havoc.

The detection of abusive patterns or fat fingered mistakes must happen in real-time, ideally before it has a chance to move the market. This approach should be taken on board not just by the regulators, but by the industry as a whole. Only then can it be one step ahead of market abuse and trading errors that cause a meltdown (or up).

As many market participants have pointed out, technology can't solve all of the problems, but it can help to give much more market transparency. To restore confidence in capital markets, organizations involved in trading need to have a much more accurate, real-time view on what's going on. In this way, issues can be prevented or at least identified much more quickly.

While I applaud Nasdaq's initiative and dedication to improving market surveillance buying Smarts, I must point out that you don't have to go quite that far to get the same results. Progress provides market-leading real-time monitoring, surveillance and pre-trade risk – powered by Complex Event Processing – enabling complex real-time monitoring of the fastest moving markets. Unlike Smarts, Progress includes the ability for business users to customize and create new scenarios rapidly (in hours rather than Smart’s months). And you don’t have to buy and integrate our company to get access to it!!