09.17.2013
By Terry Flanagan

Kill Switches Stir Controversy

The August 22, 2013 trading glitch in Nasdaq-listed securities has led to a ratcheting up of calls for so-called kill switches, but this may be a case of treating the symptoms of the problem rather than the cause.

At a meeting last week between SEC chairman Mary Jo White and the heads of U.S. exchanges, White called on all market participants “to work collaboratively – together and with the Commission – to strengthen critical market infrastructure and improve its resilience when technology falls short.”

White called on exchanges to implement kill switches that would allow them to shut down trading in the event of technological failures, and review and consider other potential risk mitigation mechanisms.

The focus on the term ‘kill switch’ has the potential to oversimplify and divert focus from the broader challenges.

“Context is of primary importance when taking stock of the proposed initiatives following the SEC meeting,” said John Edge, managing director, capital markets and business development at NICE Actimize, a provider of financial crime, risk, and compliance systems. “What has to change is the investment in surveillance and risk management to ensure our control processes and technology keeps pace. With events like Nasdaq, we are seeing warning signals for what may be much larger issues down the road if we don’t grasp the nettle now.”

White’s comments in regards to exchanges having ‘homework to do’ “are spot on in terms of the work required to assess the situation we are in,” said Edge. “There is a meaningful body of work required to identify risks and issues, largely due to the fact that capital markets have gone through an unprecedented automation evolution in what is relatively a very short time frame.”

Executing brokers perform a role in the market that is by nature, different from execution venues. “We should ensure we separate the challenges,” Edge said. “An exchange not functioning correctly is a risk to the entire marketplace if, as the trading industry is now, everything is interconnected. On the other hand, a broker not functioning is a risk to itself and a risk to market confidence; however, it is not a bottleneck, as other brokers can step in to execute.”

Exchanges require the ability to transfer the responsibility of price matching, should there be an infrastructure issue that prevents the matching of buyers and sellers on their own platform. As such, Edge suggests rephrasing the exchange requirement from a “kill switch” to a “fail-over switch.”

Also, the term switch should encompass both technology and procedures. “Mistakes can happen, and when they do, rapid identification of the issue and the ability to fail-over to a functioning alternative is essential,” said Edge. “It is here that procedures are essential as is the construct of disaster recovery solutions.”

In a company that is creating and executing orders, i.e. a broker, it is essential to employ appropriate surveillance technology, and then, if a notable change in behavior / an error occurs, be able to shut down trading quickly with a kill swtich.

Noting that shutting down trading is not as easy as implied, Edge said it requires sequential system interaction to ensure risk is managed appropriately, as such the investment required both time and technology wise is meaningful.

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