09.05.2012
By Terry Flanagan

HFT Issues Reverberate Post-Knight

The debate over how deeply regulators should ingrain themselves into algorithmic trading strategies received fresh impetus with the recent publication of a report by the U.K. government on the role of computer-based trading.

The Foresight project, sponsored by HM Treasury and led by the Government’s chief scientific adviser, Professor Sir John Beddington, explores how computer generated trading in financial markets might evolve over the next decade or more, and how this will affect financial stability and the integrity of financial markets, including price information and liquidity.

The Foresight working paper, issued last month, noted that the Markets in Financial Instruments Directive review, known as MiFID II, proposes that investment firms engaging in algorithmic trading must provide annually to the regulator a description of their algorithmic trading strategies, details of the trading parameters and limits, key compliance and risk controls which are in place, and details of how its systems are tested.

The purpose of this measure is to ensure that algorithms used in trading are subject to proper risk controls and oversight.

U.S. market maker Knight Capital was left close to bankruptcy last month following an algorithmic error that caused erratic trading activity and left the firm with billions of dollars of unwanted securities.

The Foresight report said, however, that the costs of regulatory monitoring of algorithms would outweigh the benefits.

“Unfortunately, Knight’s debacle has regulators spinning on the issue of properly tested code, something they would have little recourse to rectify or regulate,” said Louis Lovas, director of solutions at OneMarketData, a New York-based financial analytics provider. “Algos and their test environment are highly unique to individual trading styles.”

National regulators and self-regulatory organizations are establishing frameworks by which algorithms must be tested before being put into production, but so far have stopped short of requiring that the algorithms, which trading firms consider intellectual property, be registered.

Sifma, the securities industry trade group, has stated that regulatory review of firms’ source codes for algorithmic or other computer-based trading programs may be inappropriate, particularly if there is no confidentiality guarantee, as the source codes are highly sensitive and proprietary information.

Repercussions from the Knight trading snafu are still being felt, and calls for controls over HFT have been rising.

“HFT has been left unchecked and chas aused severe problems, and, in the case of Knight Capital, nearly bankruptcy,” said Mike Rhodes, senior fraud consultant at SAS, an analytics provider.

“Under heavy load, the exchange’s software can’t deal with the volume/frequency of these HFT trades, and simply crashes,” Rhodes said. “The exchanges don’t currently have the software to detect errant behavior either in real-time or near real-time to prevent circumstances.”

The Foresight working paper said that it would be imprudent to require algorithms to be submitted to regulators for a number of reasons.

Providing a full description of an algorithmic trading strategy requires not only all the programs that have been written to implement it, but also the full details of the code libraries used.

Moreover, these descriptions must include the actual computations required, and full details of how the algorithms are implemented.

Regulators would then have to analyze this material, and determine what risk, if any, an algorithm poses to the markets.

The paper concludes: “The desirability of understanding algorithmic trading strategies and their impact on the market is laudable, but achieving this through notification requirements of the type currently envisioned by MiFID II may not be feasible given the complexity of algorithms and their interactions in the market.”

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