12.05.2012
By Terry Flanagan

Exchanges Bank on ‘Kill Switches’ to Prevent Future Trading Knightmares

Following the near-demise of Knight Capital in August, exchanges on both sides of the Atlantic are now beginning to put systems in place that will act as a safety net to potentially prevent such trading glitches in the future.

The Securities and Exchange Commission set up an industry roundtable after the incident in which Knight, a market maker, sent out a flood of erroneous orders that cost the firm over $460 million in just 45 minutes of trading, to address fears over the rise of high-frequency trading in the equities market.

Regulators are beginning to move and a key takeaway to come from the SEC roundtable in October was the implementation of a so-called ‘kill switch’ to allow trading to be shut down to contain high-speed trading errors.

Exchanges in the U.S. have been the first to react, possibly in a bid to ward off more onerous legislation in the future. In September, NYSE Euronext, Nasdaq, Bats and Direct Edge all said they would be ready to monitor unusually high volumes from its members and put kill switches in place to allow for the orderly running of their markets. And last week, Direct Edge and Bats Global Markets both rolled out these new pre-trade risk controls, including automated and manual kill switches, into the software that matches orders on their exchanges.

While in Europe, Bats has become the first venue in Europe—through Bats Chi-X Europe—to put in place similar measures.

Regulators in Europe are slightly ahead of the U.S. in terms of monitoring HFT, and the European Securities and Markets Authority, or Esma, automated trading guidelines have been in place since May.

“The ability to manage effectively risk at multiple layers of the trading cycle has become increasingly essential, with pre-trade risk checks at the exchange level as well as the participant level,” said Mark Hemsley, chief executive of Bats Chi-X Europe. Bats had its own trading glitch earlier this year during its attempt at an initial public offering.

“Our risk management tools can also provide our trading participants with an additional layer of risk controls in relation to their obligations under the Esma guidelines.”

HFT now accounts for over 60% of all U.S. daily equity volumes, with that figure around 40% in Europe, and it has been blamed for other trading snafus, most notably the ‘flash crash’ of May 2010 when the Dow Jones Industrial Average index plunged 1,000 points, almost 9%, only to recover within minutes.

“Computerized trading came on strong more than a decade ago—and, it’s certainly not all bad,” said Bart Chilton, a commissioner at the Commodity Futures Trading Commission, a U.S. regulator, last month.

“But on speed, we need to keep our eyes open. There have been dozens of mini flash crashes since the big one in 2010, almost always because a machine or an algorithm ran wild. Isolated instances of runaway machines may be inevitable.

“But we can do much to protect markets. High-frequency ‘cheetah’ traders should be registered with regulators. The programs need to be tested before they go live and they need kill switches to stop them if they go feral.”

However, some believe it will be hard for the exchanges to operate these kill switches and to judge if an algorithm is actually running wild or is just sending out a lot of orders because it has a lot of orders to send out. The SEC’s Market Access Rule already requires firms to have controls in place to monitor their algorithms.

Critics also suggest that these kill switch limits will either be set too high, so will not actually come into play at all, or will just not be quick enough to prevent trading glitches or more risky plays by HFT firms in a real-time environment, where millions can be made or lost in the blink of an eye.

“The aim of every financial institution is to get to the market as quickly as possible,” Simon Garland, chief strategist of Kx Systems, a U.S.-based provider of high-performance database and time series analysis, told Markets Media earlier this year. “So technologists pull out all the stops to get the best possible performance.

“If someone has played every trick in the book to get in and trade or do something, there’s no way any monitoring could be looking at what they are doing and seeing if that is sensible. They can’t say, ‘wait, stop’. It’s already moved on 100 meters down the road by then.”

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